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LIBRARY 


BANK  CREDIT 


THE  MACMILLAN  COMPANY 

NrW   YORK   •    BOSTON    •    CHICAGO    •   DALLAS 
ATLANTA    •    SAN   FRANCISCO 

MACMILLAN  &  CO.,  Limited 

LONDON    •   BOMBAY    •  CALCUTTA 
MELBOURNE 

THE  MACMILLAN  CO.  OF  CANADA,  Lm 

TORONTO 


BANK  CREDIT 


A  STUDY  OF  THE  PRINCIPLES  AND  FACTORS 

UNDERLYING  ADVANCES  MADE  BY 

BANKS  TO  BORROWERS 


BY 
CHESTER  ARTHUR  PHILLIPS.Ph.D. 

PROFESSOR  OP  ECONOMICS  IN   DARTMOUTH  COLLEGE  AND  PROFESSOR 

OF  BANKING  AND  FINANCE  IN  THE  AMOS  TUCK  SCHOOL 

OF    ADMINISTRATION    AND    FINANCE 


'»     J  J •  • • I 


Npuj  f  ark 

THE  MACMILLAN  COMPANY 

1924 


AU  rights  referved 


Copyright,  1920 

bt  the  macmillan  company 


Set  up  and  electrotyped.    Published  August,  1920. 


\ 


f\ 


PREFACE 

The  purpose  of  this  study  is  two-fold :  to  develop  the 
principles  of  bank  credit  considered  in  the  abstract  and 
to  set  forth  the  main  factors  underlying  the  loans 
made,  the  credit  extended,  by  banks  to  borrowers. 

Part  One  is  devoted  mainly  to  an  explanation  of  the 
way  in  which  cash  in  banks  becomes  the  basis  of  mani- 
fold loans  and  deposits,  and  to  a  statement  of  the  rela- 
tion of  loans  to  the  other  principal  items  of  the  bank 
balance  sheet. 

The  burden  of  Part  Two  is  a  consideration  of  the 
I,     factors  underlying  and  affecting  the  soundness  of  the 
■*;'  contents  of  banks'  portfolios.     It  has  seemed  natural 
and  logical  to  give  a  somewhat  detailed  account  of 
recent  changes  in  our  bank  credit  arrangements,  in- 
cluding the  evolution  of  the  form  of  the  bank  borrow- 
er's obligation,  the  growth  of  the  note  brokerage  busi- 
i    ness,  the  establishment  of  the  bank  credit  department, 
^    and  the  rise  of  the  new  business  department  and  its 
c    effects  on  the  quaUty  of  bank  loans.     The  work  of 
^'    note  brokers  acting  as  middlemen  between  borrowers 
and  banks  has  been  given  what  seems  a  deservedly 
large  place. 

The  structure  of  Part  One  is  built  in  part  on  old  and 
familiar  foundations,  and  in  part  on  foundations 
newly  laid.  The  main  sources  of  Part  Two  are  the  Pro- 
ceedings of  the  American  Bankers'  Association,  pro- 


vi  PREFACE 

cecdings  of  the  various  state  bankers'  associations, 
reports  of  the  Comptroller  of  the  Currency,  and 
banking  periodicals.  Information  embodied  chiefly  in 
chapters  VII-XI  and  XVI,  and  unobtainable  from 
the  ordinary  sources,  was  secured  by  extensive  corre- 
spondence and  interviews  with  bankers  and  note  brok- 
ers, to  whom  my  sincere  thanks  are  due. 

For  invaluable  suggestions  I  am  grateful  to  Profes- 
sors Ray  B.  Westerfield,  Fred  R.  Fairchild  and  Irving 
Fisher,  of  Yale. 

Chester  A.  Phillips 
Hanover,  N.  H. 


TABLE  OF  CONTENTS 

Chapter  ^^®^ 

I.  Introduction 1 

The  Nature  of  Bank  Credit 1 

The  Bank  Acceptance  as  Bank  Credit 1 

Are  Deposits  Bank  Credit 2 

Bank  Credit  vs.  Commercial  Credit 3 

The  Legitimate  Scope  of  Bank  Credit  Extension 4 


PART  I 

QUANTITATIVE  ASPECTS  OF  BANK  CREDIT 

II.  The  Nature  of  Commercial  Banking 13 

Banking  Transactions  and  Accounts 13 

Expansion  of  Loans  a  Prelude  to  Loss  of  Cash 20 

Protective  LiabiHties 22 

Concealed  Assets  and  Liabilities 29 

III.  The  Philosophy  of  Bank  Credit 32 

A  Critical  Analysis  of  the  Traditional  Theory 34 

Loan  and  Deposit  Expansion  within  the  Banking 

System 38 

Primary  and  Derivative  Deposits  Differentiated 40 

The  Ratio  of  Derivative  Deposits  to  Loans 44 

Factors  Determining  the  Ratio  of  Derivative  De- 
posits to  Loans 46 

Aggregate   Derivative   Deposits   Tend   to   Remain 

Constant  in  Amount 52 

Quantitative  Determination  of  Individual  Bank 
Loan  Expansion  Traceable  to  Acquisition  of  Prim- 
ary Deposits 54 

vii 


viii  TABLE  OF  CONTENTS 

Chapter  Page 

Qualifications  of  the  Formula 57 

The  Distribution  of  New  Reserve  as  the  Foundation 

of  INIanifold  New  Loans 59 

Relation  of  Loans  to  Deposits 63 

How  the  Withdrawal  of  Cash  from  an  Individual 
Bank  Effects  a  Wide-Spread  Contraction  of  Loans 

and  Deposits 64 

Why  Banks  Compete  for  Deposits 66 

The   Assimilation   of   an   Individual   Bank   to    the 

System 68 

The  Essential  Difference  between  the  Old  Theory 

and  the  New 72 

Anticipated  Criticism  Answered 74 

TV.  Inter-Rel.\tions  of  Cash,  Loans  and  Deposits 77 

Cash  in  Relation  to  Loan  Expansion  in  Individual 

and  Collective  Banking 77 

Regulation  of  Ratio  of  Cash  to  Deposits  in  Individual 

Banking 79 

Ratio  of  Cash  to  Deposits  and  to  Loans  in  the  Bank- 
ing System 82 

V.  Surplus  in  Relation  to  Loans,  Deposits  and  Re- 
serves    84 

A  New  but  Erroneous  Doctrine  of  Surplus 84 

The  Doctrine  Disproved 87 

The  Relation  of  Cash  or  Reserve  to  Surplus 94 

The  Ratio  of  Cash  to  Deposits  and  of  Surplus  to 

Creditor  LiabiHties 96 

The  Relation  of  Cash  to  Deposits  vs.  the  Relation  of 

Surplus  to  Creditor  Liabilities 102 

VI.  Bankers'  Banks  and  Credit  Extension 103 

The  Nature  of  Bankers'  Banks 103 

Bankers'  Banks  Dilute  Cash 104 

Federal  Reserve  Banks  Illustrative 104 

Future  Credit  Expansion  under  the  Federal  Reserve 

System 112 

The  Rediscount  Rate  as  a  Factor  in  Credit  Extension  114 

Commercial  Banks  as  Bankers'  Banks 119 


TABLE  OF  CONTENTS  IX 

PART  II 
QUALITATIVE  ASPECTS  OF  BANK  CREDIT 

^  Page 

Chapter 

VII   Recent  Changes  in  our  Bank  Credit  Arrange- 

10Q 
ments 

Evolution  in  the  Form  of  the  Borrower's  Obligation .   123 

The  Growth  of  Note  Brokerage 131 

Seasonal  Demands  for  Funds  in  Relation  to  the 

Growth  of  Note  Brokerage 138 

Independent  Banking  and  the  Rise  of  Note  Broker- 
age    139 

The  New  Attitude  of  Bankers  toward  Brokers' 

Paper 1^1 

The  Rise  of  the  Credit  Department 142 

The  First  Phase  of  the  Development  of  Credit  Re- 
search     144 

The  Development  of  the  Credit  Department  since 

1900..." 146 

The  Underlying  Forces ■  ■   148 

The  Rise  of  the  New  Business  Department  and  its 

Relation  to  the  Credit  Department 152 

The  Influence  of  the  Federal  Reserve  System  upon 

the  Kinds  and  Quality  of  Bank  Loans 156 

VIII.  The  Bank  Borrower's  Statement:  Assets 160 

Cash  on  Hand  and  in  Banks 165 

Accounts  and  Notes  Receivable 169 

Merchandise  or  Inventory 173 

Real  Estate,  Machinery  and  Equipment 179 

Other  Assets 1^2 

Stocks  and  Bonds 183 

Trade-Marks,  Patents,  Goodwill,  etc 184 

Life  Insurance 1^6 

IX.  The  Bank  Borrower's  Statement:  Liabiuties 189 

Bills  Payable  for  Merchandise 189 

Bills  Payable  to  own  Banks 189 

Bills  Payable  for  Paper  Sold 190 


X  TABLE  OF  CONTENTS 

Chapter  Page 

Open  Accounts 191 

Chattel  IMortgnges 192 

Bonded  Debt  and  Interest  Thereon 192 

Deposits  of  Money  with  Us 193 

Other  Liabihties 194 

Capital  and  Surplus,  Proprietorship  Interest,  or  Net 

Worth 196 

Ratio  of  Quick  Assets  to  Current  Liabilities 197 

Relation  of  Net  Worth  to  Credit  Worth 198 

X.  The  Bank    Borrower's   Statement:   The    Income 

Account 199 

Insurance 201 

Salaries  and  Cash  Withdrawals 201 

Depreciation 202 

Sales 204 

Net  Profits 205 

Dividends 206 

The  Borrower's  Capacity 207 

Reciprocal  Benefits  of  the  Bank  Borrower's  Statement  209 
Significance  of  Refusal  to  Render  Statement 211 

XI.    Im'ESTIGATING  THE  CrEDIT  RiSK 214 

Handbooks  as  a  Source  of  Information 215 

The  Mercantile  Agencies 215 

The  Trade 216 

Banks 219 

The  Interview 221 

The  Method  of  Investigation  in  a  Particular  Case. .  222 

XII.  Secured  Lo.ins 224 

Warehouse  Loans 226 

Cotton  Loans 229 

Crop  Loans 230 

Real  Estate  Mortgage  Security 231 

Urban  Real  Estate 231 

Farm  Land  as  Security 232 

XIII.  0%terdrafts 235 

Objectionable  Features 237 

In  State  and  National  Banks 238 


TABLE  OF  CONTENTS  XI 

Chapter  ^^^^ 

Rules  for  Controlling  Overdrafts 239 

Depend  upon  Bank  Supervision 240 

An  Index  of  the  Soundness  of  the  Bank 241 

XIV.  Loans  of  Country  Banks 242 

Distinctive  Features  of  Country  Bank  Loans 242 

Rules  for  Reducing  Slow  and  Past  Due  Paper 248 

Loans  to  Tenants 249 

The  Rate  of  Interest 250 

XV.  Loans  of  Banks  to  Banks 253 

Methods  of  Lending 253 

Investigating  the  Borrowing  Bank 256 

A  Particular  Case 258 

XVI.  Commercial  Paper  Houses  as  Intermediaries  be- 

tween Borrowers  and  Banks 260 

Characteristic  Features 261 

The  Paper 262 

The  Volume  of  Note  Brokerage  Business 264 

Ten  Days'  Option 265 

The  Broker's  Profit 265 

Advantages  of  the  Note  Brokerage  System  to  Bor- 

267 
rowers 

Disadvantages  to  the  Borrower 270 

Advantages  of  the  Note  Brokerage  System  to  Banks  271 

Disadvantages  to  the  Bank 277 

Weaknesses  of  the  System 277 

Correctives ^°' 

XVII.  Bank  Supervision  in  Relation  to  Bank  Credit 295 

National  Bank  Supervision 296 

State  Bank  Supervision 299 

Clearing  House  Bank  Examination 302 

The  System  Described 304 

Influence  upon  Loans  of  Small  Banks 309 

Effects  upon  Loans  to  "Double"  Borrowers  in 

Large  Cities ^^^ 

Incidental  Effects  upon  Loans 312 

Internal  Bank  Examination 315 

Conclusion ^^^ 


xii  TABLE  OF  CONTENTS 

Chapter  Page 

Appendix  A.  Questions,  Exercises,  and  Problems 319 

Appendix  B.  Borrowers'  Statement  Forms  Designed  and  Ap- 
proved by  the  American  Bankers  Association, 
Including  the  Report  of  Committee  on  Credit 
Forms 356 


FOREWORD  TO  TEACHERS 

The  main  circumstance  prompting  the  pubhcation  of 
this  volume  is  the  lack  of  any  work  well  designed  to 
familiarize  the  student  with  the  theory  of  banking  in 
both  its  abstract  and  concrete  aspects.  At  a  time  when 
banking  policy  promises  for  years  to  come  to  be  the 
continuing  source  of  many  of  our  most  vital  economic 
problems,  the  value  of  a  masteiy  of  banking  theory 
becomes  apparent  and  method  of  study  important. 
The  author  believes  that  mastery  can  be  gained  most 
advantageously  through  the  solution  of  questions  and 
problems  directly  related  to  the  text  studied  and  ac- 
cordingly presents  extensive  ' '  Questions,  Exercises,  and 
Problems"  in  Appendix  A. 

Many  of  the  questions,  exercises,  and  problems  are 
integrated  with  the  text  and  the  numerous  teachers 
who  rely  chiefly  on  the  Socratic  method  may  profitably 
direct  considerable  attention  to  their  solution,  notably, 
in  connection  with  chapters  II,  III,  VI,  VIII-X.  It 
would  be  conducive  to  thoroughness  if  chapters  II  and 
III  and  the  corresponding  portions  of  Appendix  A  were 
broken  into  not  fewer  than  five  assignments,  e.  g.,  as 
follows : 

1.  Pages  13-29  and  relative  questions  and  problems 
1-16. 

2.  Pages  29-31  and  relative  questions  and  problems 
17-26. 


xiv  FOREWORD  TO  TEACHERS 

3.  Pages  32-51  and  relative  questions  and  problems 
1-10. 

4.  Pages  52-63  and  relative  questions  and  problems 
11-25. 

5.  Pages  63-74  and  relative  questions  and  problems 
26-37. 

The  method  of  handling  other  works  used  jointly 
with  Bank  Credit  may  be  passed  over  \Ndthout  comment 
except  that  a  preliminary  study  of  the  bank  balance 
sheet  and  of  clearing  and  collection  facilities  and 
methods  would  be  desirable,  although  not  essential. 
The  famihar  texts  of  Dimbar,  White,  Holdsworth,  Scott, 
and  Moulton  contain  suitable  introductory  or  collateral 
material. 

It  is  in  place  to  say  that  the  purpose  of  the  sharp 
conflict  of  theory  with  theory  in  chapters  III  and  V  is 
primarily  not  to  expose  the  fallacy  of  the  false,  but  to 
demonstrate,  clarify,  and  enforce  the  truth  of  the  true. 


BANK  CREDIT 


BANK   CREDIT 

CHAPTER  I 

Introduction 

The  Nature  of  Bank  Credit 

Bank  credit,  as  the  term  is  used  in  this  volume, 
stands  for  credit  extended  by  banks  to  borrowers. 
Bankers  frequently  use  the  term  in  the  plural,  meaning 
advances  made  to  their  borrowing  customers.  Whether 
the  borrower  withdraws  the  amount  of  the  proceeds  of 
his  loan  in  cash  at  once  or  leaves  it  on  deposit  with  the 
lending  bank,  the  loan  in  either  case  constitutes  credit 
extended.  Just  as  a  merchant  extends  credit  to  the 
customer  who  pays  for  his  purchase  at  a  later  time, 
so  the  banker  extends  credit  to  the  business  man  who 
borrows  money.  Whether  the  money  is  taken  from  the 
bank  at  the  time  the  loan  is  made,  the  next  day,  or  ten 
days  later,  makes  no  essential  difference;  bank  credit 
may  take  even  the  form  of  an  overdraft. 

The  Bank  Acceptance  as  Bank  Credit 

The  bank  acceptance,  which  is  a  draft  or  bill  drawn 
upon  and  accepted  by  a  bank,  differs  from  a  loan  in 
the  fact  that  the  accepting  bank  makes  no  actual  ad- 
vance of  funds;  it  meets  its  obligation  at  the  maturity 

1 


2  BANK  CREDIT 

of  the  draft  out  of  funds  provided  by  the  drawer.  The 
accepting  bank  has  faith  in  the  wilHngness  and  abiUty 
of  the  drawer  to  provide  the  funds  required  to  meet  the 
draft  when  it  matures,  but  the  habihty  assumed  is  es- 
sentially contingent,  the  advance  being  made  by  the 
bank  or  discount  house  that  buys  the  bill. 

A  bank  with  low  reserves  may  be  disinclined  to  make 
a  loan,  but  quite  willing  to  accept  a  draft  that  is  pay- 
able at  a  future  date  out  of  funds  provided  by  the 
drawer.  The  accepted  draft,  being  the  obligation  of  a 
bank,  finds  a  market  wherever  banks  have  redundant 
funds.  The  bank  acceptance,  therefore,  works  in  the 
direction  of  a  more  nearly  complete  equilibration  of 
demand  for  and  supply  of  the  purchasing  powder  that 
banks  make  it  their  business  to  lend.  The  accepting 
bank  buttresses  the  credit  standing  of  the  drawer,  who 
then  secures  the  funds  desired  from  a  lending  institu- 
tion. An  acceptance  credit  has  an  important  direct 
influence  upon  neither  the  deposits  nor  reserves  of 
banks;  actual  advances  affect  both  items  directly. 
Hence,  from  the  standpoint  of  banking  theory,  the 
acceptance  credit  is  comparatively  unimportant. 

Are  Deposits  Bank  Credit? 

It  happens,  also,  that  borrowers  extend  credit  to 
banks,  when  either  cash  or  the  proceeds  of  loans  are 
lodged  with  their  banks.  Deposits  are  obviously  closely 
related  to  loans,  both  in  an  individual  bank  and  in  a 
banking  system,  but  that  close  relationship  scarcely 
justifies  the  application  of  the  term  bank  credit  to  de- 
posits. Whether  arising  from  the  lodgment  of  cash  or 
of  the  proceeds  of  loans  in  a  bank,  deposits  represent 


INTRODUCTION  3 

credit  extended  by  the  bank's  customers  to  the  bank. 
However,  partly  out  of  deference  to  the  reader  who  may 
insist  that  deposits  also  are  bank  credit,  and  partly 
because  of  the  close  relation  of  deposits  to  loans,  a  dis- 
cussion of  the  deposit  item  in  its  relation  to  loans,  sur- 
plus and  cash  is  given  in  later  pages. 

Bank  Credit  vs.  Commercial  Credit 

The  fundamental  factors  affecting  the  question  of 
security  or  safety  are  essentially  the  same  in  mercantile 
and  bank  credit.  The  banker  and  the  wholesaler  and 
jobber  are  about  equally  concerned  with  such  matters 
as  the  ratio  of  quick  assets  to  current  liabilities,  net 
worth,  the  moral  hazard,  etc.  Both  the  banker  and  the 
business  man  who  sells  on  credit,  tap  substantially  the 
same  sources  of  credit  information.  Methods  of  in- 
vestigating the  credit  risk  are  substantially  the  same. 
In  collecting  credit  information  the  trade  reUes  heavily 
on  the  banks  and  the  banks  rely  heavily  on  the  trade. 

The  essential  difference  between  bank  credit  and 
commercial  credit  lies  in  the  degree  of  certainty  of  pay- 
ment. The  banker's  percentage  of  profit  is  so  small  in 
comparison  with  the  profit  of  the  merchant  or  manu- 
facturer who  extends  credit  to  his  customers  that  the 
banker  is  compelled  to  take  greater  precaution  con- 
cerning repayment  of  a  loan  than  is  the  business  man 
in  regard  to  payment  for  wares  sold. 

The  mercantile  credit  man  considers  himself  for- 
tunate if  the  losses  of  his  house  do  not  exceed  1/4  or  1/3 
of  1  per  cent  of  his  total  sales.  The  banker,  whose  dis- 
count is  small  in  comparison  with  the  profits  of  the 
merchant,  regards  as  serious  the  loss  of  even  1/100  of 


4  BANK  CREDIT 

one  per  cent  of  his  turnover.^  It  was  estimated  in  1892, 
by  Mr.  E.  S.  Lacey,  a  former  Comptroller  of  the  Cur- 
rency, that  the  losses  on  loans  and  discounts  made  by 
national  banks  at  that  time  amounted  to  1/200  of  one 
per  cent.- 

Another  distinctive  feature  of  bank  credit  is  that  a 
bank  is  commonly  able  to  make  loans  in  excess  of  the 
amount  of  cash  received  from  shareholders  and  deposi- 
tors. How  much  in  excess  is  a  question  that  is  an- 
swered in  chapter  III. 

The  Legitimate  Scope  of  Bank  Credit  Extension 

It  is  not  the  most  approved  business  of  a  bank  to  fur- 
nish the  fixed  capital  of  an  enterprise.  The  fixed  capital 
requirements  of  a  business,  as  distinct  from  short  time 
credit  needs,  must  be  met  before  banking  accommo- 
dation can  safely  be  extended,  and  borrowers  should  in 
general  rely  on  banks  for  seasonal  requirements  only. 
WTiat  the  banker  may  most  legitimately  furnish  will  be 
made  clear  by  an  illustration.  A  clothing  merchant 
proposes  to  set  up  in  business.  He  expects  to  carry  a 
stock  of  goods  worth  on  the  average  about  $25,000. 
If  he,  without  capital  of  his  own,  should  make  appHca- 
tion  for  a  bank  loan  of  that  amount,  the  application 
would  in  all  but  the  most  exceptional  cases  be  refused, 
because  the  banker,  who  handles  chiefly  the  funds  of 

1  Norman  I.  Adams,  Credit  Department,  Analysis  of  the  Financial 
Statement,  A  lecture  delivered  before  the  Boston  Chapter  of  the 
American  Institute  of  Banking,  February  4,  1913,  p.  4. 

^  E.  S.  Lacey,  Some  Phases  of  Modern  Banking,  Proceedings, 
Second  Annual  Meeting,  Bankers'  Association  of  the  State  of 
Illinois,  1892,  p.  50. 


INTRODUCTION  5 

others,  cannot  advisedly  place  those  funds  where  so 
large  a  risk  would  obtain. 

The  merchant  might  secure  his  capital  through  the 
partnership  f  orai  of  organization  or,conceivably,  through 
the  issue  and  sale  of  corporate  securities.  In  any  event 
the  bank  would  have  to  insist  that  the  merchant  com- 
mence business  with  a  capital  approximately  as  indi- 
cated. With  those  requirements  met,  the  merchant 
would  be  in  a  favorable  position  to  apply  for  a  loan  to 
finance  his  somewhat  extraordinary  needs  in  the  buying 
seasons,  the  spring  and  fall.  The  capital  invested  would 
stand  as  a  buffer  between  any  losses  that  might  occur 
in  the  conduct  of  the  mercantile  business  and  the  in- 
terests of  the  lending  bank.  It  is  plain  that  if  a  bor- 
rower fully  repays  his  bank  loans  seasonally  it  is 
presumptive  evidence  that  the  banker  is  not  being  re- 
quired to  furnish  a  part  of  the  capital  fixed  in  the  busi- 
ness. Many  banks  insist  on  a  ''clean  up"  at  least  once 
a  year. 

The  question  naturally  arises,  why  should  the  mer- 
chant,— and  the  same  would  apply  to  a  manufacturer 
or  other  entrepreneur, — not  have  sufficient  capital  in- 
vested in  the  business  to  meet  all  needs,  even  those 
arising  at  the  time  of  seasonal  purchases  or  expansion? 
Relatively  few  concerns  are  so  situated  that  borrowing 
from  banks  is  unnecessary.  The  reason  is  that  the 
possession  of  sufficient  capital  to  enable  a  firm  to  follow 
that  course  would  involve,  ordinarily,  an  appreciable 
waste  through  loss  of  income  on  funds  which,  although 
available  for  use  twelve  months  in  the  year,  would  be  in 
active  use  only  a  fraction  of  that  time. 

It  is  important  that  emphasis  be  placed  on  the  dis- 


6  BANK  CREDIT 

tinction  between  fixed  capital  requirements  and  those 
credit  requirements  of  a  business  which  recur  annually 
or  seasonally.  Separate  and  distinct  methods  ought  to 
be  observ'ed  in  meeting  each  class  of  requirement. 
Business  men  should  first  provide  for  the  capital  req- 
uisite to  start  business  on  a  sound  basis;  then,  should 
have  banking  accommodation  adequate  to  enable  them 
successfully  to  cany  on  that  business.^ 

A  maximum  of  profit  to  the  borrower  of  funds  and  a 
minimum  of  risk  to  the  lending  bank, — these  fre- 
quently represent  conflicting  considerations,  and  it 
would  not  be  in  harmony  with  the  facts  to  suppose  that 
business  concerns  confine  their  borrowing  operations 
to  strictly  seasonal  or  temporary  needs.  The  practice 
of  business  concerns  selling  notes  through  note  brokers, 
described  in  chapter  XVI,  and  the  practice  of  maintain- 
ing more  than  one  bank  account  militate,  along  with 
other  circumstances,  against  the  ability  and  disposition 
of  bankers  to  limit  the  extension  of  credit  to  the  satis- 
faction of  seasonal  needs  only.  It  is  well  known  that 
many  wholesale,  jobbing  and  manufacturing  concerns 
now  keep  large  amounts  of  paper  afloat  continuously. 
That  is,  banks  are  supplying  not  only  their  short-time 
or  seasonal  needs,  but  a  part  of  their  long-time  capital 
needs  as  well, — a  circumstance  that  danger  attends 
unless  the  proportion  of  liquid  assets  is  kept  ample.  ^ 

1  Cf.  Charles  Hall  Davis,  The  Davis  Plan  of  Rural  Banks,  Pro- 
ceedings, Seventeenth  Annual  Convention,  North  Carolina  Bank- 
ers' Association,  1913,  pp.  29-32. 

2  Professor  Harold  G.  Moulton  has  thrown  a  flood  of  light  on  the 
liquidity,  or  rather  lack  of  liquidity,  of  American  bank  loans.  See 
his  articles  on  Commercial  Banking  and  Capital  Formation,  Journal 


INTRODUCTION  7 

It  is  also  true  that  commercial  banks  customarily 
invest  a  part  of  their  funds  in  long-time  securities,  es- 
pecially bonds,  a  practice  that  carries  with  it  a  danger 
of  shrinkage  in  value  due  to  changes  in  the  long-time 
rate  of  interest.  Large  cash  holdings  and  other  liquid 
assets  in  ample  amount  are  designed  to  obviate  the 
danger  arising  from  advances  made  on  renewable  paper, 
even  though  the  proceeds  are  invested  in  fixed  form,  but 
only  large  capital,  surplus,  and  undivided  profits  will 
meet  the  situation  if  the  prices  of  bonds  held  by  banks 
shrink,  as  shrink  they  do,  when  long-time  funds  be- 
come scarce  and  the  interest  rate  rises. 

The  disposition  of  borrowers  to  rely  increasingly  on 
continuous  loans  as  against  those  of  short  and  certain 
maturity  is  traceable  in  part  to  two  facts  or  tendencies. 
In  the  first  place  the  demand  for  ''seasonal"  loans  of 
short-time  duration,  has  fallen  off  relatively,  owing  to 
our  improved  facihties  for  distributing  and  storing. 
As  it  is  almost  always  possible  to  obtain  promptly  any 
article  needed  for  the  consumers'  trade  there  is  no 
great  advantage  in  heavy  seasonal  buying  under  or- 
dinary conditions,  and  the  need  of  seasonal  borrowing 
is  accordingly  rendered  less  imperative.' 

A  second  circumstance  that  has  caused  the  demand 
for  seasonal  funds  to  decline  relatively  to  that  for  fixed 
capital  has  been  the  tendency  to  use  more  and  more 
capital  in  relation  to  labor  in  both  production  and  dis- 

of  Political  Economy,  Vol.  26  (1918),  particularly  article  III,  pages 
705-31. 

»  Cf.  Asael  E.  Adams,  As  to  the  Efficiency  of  our  Present  System, 
Proceedings,  Twenty-fourth  Annual  Convention,  Ohio  Bankers' 
Association,  1914,  pp.  44,  45. 


8  BANK  CREDIT 

tribution.  Every  new  labor  saving  device  introduced 
has  involved  an  increase  in  capital  needed  in  the  line 
in  ^Yhich  that  device  is  used,  relative  to  the  amount  of 
liquid  or  short  time  funds  required.^ 

In  one  sense  continuously  floating  paper,  when  mar- 
keted by  note  brokers,  is  liquid,  and  in  another  it  is  not. 
From  the  standpoint  of  an  individual  bank  it  is  ordin- 
arily very  liquid,  although  in  times  of  crisis  the  makers 
might  experience  difficulty  in  meeting  their  obhgations. 
From  the  standpoint  of  the  banks  taken  as  a  whole  this 
paper,  put  on  the  market  by  brokers  wherever  buyers 
among  banks  can  be  found,  is  distinctly  non-liquid. 
From  the  standpoint  of  the  borrowing  concern  the 
floating  of  paper  continuously  in  the  market  is  almost 
tantamount  to  the  issue  and  sale  of  bonds.  From  the 
standpoint  of  the  banking  system  the  floating  of  such 
paper  is  also  almost  equivalent  to  the  sale  of  bonds  to 
the  banks;  but  from  the  standpoint  of  the  individual 
bank  the  short  time  paper  is  hquid  and  mobile.  In 
an  ideal  bank  credit  situation  continuously  floating 
paper  would  not  be  outstanding  and  borrowers  would 
completely  pay  their  obligations  to  banks  at  least  once 
a  year.  The  business  or  trade  that  has  a  season  longer 
than  a  year  is  rare,  perhaps  non-existent. 

At  the  same  time  some  lines  of  business,  hke  that  of 
the  tanner,  whose  vats,  always  filled,  impel  him  to 
borrow  money  ''every  day  in  the  year,"  are  non- 
seasonal  and  yet  make  heavy  demands  upon  the  loan- 
able funds  of  banks.  There  is  no  good  reason  in  such 
cases  why  banks  should  not  lend,  provided  the  ratio 
of  quick  assets  to  current  liabiUties  is  adequate,  the 

1  Ibid. 


INTRODUCTIOI^  9 

capital  or  net  worth  of  the  borrower  ample,  and  the 
other  elements  in  the  situation  favorable. 

What  the  commercial  banker  ought  assiduously  to 
avoid,  even  where  loans  are  based  on  time  deposits, 
is  the  unliquid  condition  of  the  loan  item  that  exists 
when  his  funds  are  invested  heavily  in  fixed  form,  in 
real  estate,  equipment,  etc.  Repayment  then  becomes 
a  matter  not  of  days  or  months,  but  of  years,  and  may 
be  extremely  uncertain. 

In  succeeding  chapters  we  shall  consider  in  detail 
the  nature  of  the  process  involved  in  the  manufacture 
of  bank  credit,  the  relation  of  loans  to  other  magni- 
tudes in  the  balance  sheet  in  both  individual  and  col- 
lective banking,  the  recent  evolution  of  our  bank  credit 
arrangements,  the  bases  of  bank  loans,  and  the  in- 
fluence of  certain  institutions  and  practices  upon  the 
quahty  of  the  contents  of  the  banker's  portfolio.  A 
brief  study  of  banking  operations  and  accounts,  de- 
signed to  make  clear  the  nature  of  commercial  bank- 
ing, is  given  in  the  next  chapter  as  an  essential  pre- 
liminary to  the  development  of  principles  attempted 
in  the  pages  that  foUov/. 


PART  I 

QUANTITATIVE  ASPECTS  OF  BANK 
CREDIT 


CHAPTER  II 

The  Nature  of  Commercial  Banking 

The  lending  functions  of  a  commercial  bank  are 
so  radically  different  from  those  of  the  money  lender, 
putting  out  only  his  own  funds,  that  it  will  be  desirable 
at  the  outset  to  consider  carefully  the  nature  of  bank- 
ing, the  essence  of  which  consists  in  the  practice  of 
extending  loans  far  in  excess  of  either  the  capital  or 
cash  holdings  of  the  bank  in  question.  A  glimpse  of 
the  difference  between  bank  loans  and  the  loans  of  a 
money-lender  will  be  gained  if  we  examine  the  balance 
sheet  of  a  bank  as  the  institution  expands  on  the  basis 
of  the  cash  paid  in  by  the  shareholders  in  exchange  for 
shares  of  stock. 

Banking  Transactions  and  Accounts 

Following  the  customary  practice  of  setting  down 
the  assets  and  liabilities  on  opposite  sides  of  the  balance 
sheet,  we  note  first  that  the  payment  of,  say,  $100,000 
capital  stock,  one  thousand  shares  of  $100  each,  will 
result  in  the  creation  of  assets  and  liabilities  as  follows: 

Assets                                            Liabilities 
Cash $100,000    Capital  Stock $100,000 

The  balance  sheet  shows  cash  as  an  asset, — debt 
paying  power, — and  capital  stock  as  a  debt.  Some- 
times "capital  stock"  is  shortened  to  "capital,"  in 

13 


14  BANK  CREDIT 

which  case  the  reader  may  have  difficulty  in  bearing 
clearly  in  mind  that  capital  really  means,  not  the  cash 
paid  in  by  the  shareholders,  but  what  the  bank  as  an 
institution  owes  the  shareholders  on  account  of  their 
cash  contributions  to  the  enterprise.  Capital  stock  or 
capital  is  always  a  liability  of  the  bank. 

It  would  be  natural  for  many  of  the  shareholders 
to  transfer  their  accounts  from  older  banks  to  the 
new,  and  we  may  suppose  that  cash  amounting  to 
S50,000  is  deposited  by  shareholders.  The  balance 
sheet  or  financial  statement  will  then  read : 

Assets  Liabilities 

Cash $150,000    Capital $100,000 

Deposits 50,000 


$150,000  $150,000 

Local  business  men,  friendly  to  the  promoters  of  the 
new  bank,  also  open  accounts,  depositing  $5,000  in 
cash  and  $20,000  in  checks  on  other  banks.  Our 
statement  will  now  show: 

Assets  Liabilities 

Cash $155,000    Capital $100,000 

Due  from  Other  Banks .     20,000    Deposits 75,000 


$175,000  $175,000 

During  the  early  history  of  the  bank,  connection 
will  have  been  established  with  one  or  more  metropoli- 
tan banks,  and  a  deposit  balance  created.  The  pri- 
mary reasons  for  the  maintenance  of  balances  on  de- 


THE   NATURE   OF  COMMERCIAL  BANKING         15 

posit  with  banks  in  centers  to  which  the  locahty  of  a 
given  bank  is  commercially  tributary  are  (1)  that  the 
local  bank  may  be  able  to  sell  drafts  on  those  centers, 
for  the  accommodation  of  its  customers  who  may  de- 
sire to  remit  drafts  as  means  of  payment,  and  (2)  that 
the  local  bank  may  have  agents  in  the  centers  to  handle 
and  collect  drafts  drawn  by  dealers  or  manufacturers 
who  have  shipped  goods  to  distant  markets,  and  (3) 
that  the  local  bank  may  have  collection  agencies  for  the 
stream  of  checks  deposited  daily  by  its  customers. 

It  would  be  reasonable  for  a  bank  having  a  capital 
of  $100,000  to  place  $25,000,  more  or  less,  on  deposit 
with  one  or  more  banks  in  commercial  and  financial 
centers  to  which  the  locality  of  the  bank  with  which  we 
are  concerned  is  tributary.  Cash  would  then  be  re- 
duced $25,000  and  ''due  from  banks"  would  be  in- 
creased to  $45,000.    The  statement  would  stand: 

Assets  Liabilities 

Cash $130,000    Capital $100,000 

Due  from  Other  Banks .     45,000    Deposits 75,000 


$175,000  $175,000 

Applications  for  loans  amounting  to  $20,000  are 
received  and  approved.  The  average  time  is  90  days 
and  the  rate  6  per  cent;  the  discount  amounting  to 
$300.  The  proceeds,  $19,700,  are  left  on  deposit  to  be 
drawn  against  by  check.  This  lending  transaction 
introduces  into  the  statement  some  new  items.  Loans 
and  discounts,  being  valuable  instruments  in  the  pos- 
session of  the  bank,  will  take  a  place  on  the  asset  side 


16 


BANK  CREDIT 


of  the  statement;  deposits  will  be  increased  by  the 
amount  of  the  proceeds  of  the  loans;  the  discount, 
which  is  profit  undivided  and  belonging  to  the  share- 
holders, will  be  recorded  as  a  liabihty  under  the  head  of 
undi\dded  profits.  Assets  and  liabilities  have  grown  to 
the  following  proportions: 


Assets 
Loans  and  Discounts  . .  S  20,000 
Due  from  Other  Banks .     45,000 
Cash 130,000 


$195,000 


Liabilities 

Capital $100,000 

Undivided  Profits 300 

Deposits 94,700 


$195,000 


The  directors  of  our  bank  feel  that  the  amount  of 
cash  lying  idle  in  the  vault  is  unduly  large  and  vote 
to  buy  $30,000  worth  of  bonds  and,  confident  of  the 
future,  also  vote  to  invest  $5,000  in  a  well  located 
vacant  lot  on  which,  in  the  fullness  of  time,  to  erect 
a  new  banking  house.  The  purchase  of  the  bonds  and 
real  estate  for  cash  is  now  reflected  in  the  balance 
sheet. 


Assets 
Loans  and  Discounts. .  .  $  20,000 
Due  from  Other  Banks .     45,000 

Real  Estate 5,000 

Bonds 30,000 

Cash 95,000 


Liabilities 

Capital $100,000 

Undivided  Profits 300 

Deposits 94,700 


$195,000 


$195,000 


An  overdraft,  which  occurs  when  the  bank  allows 
an  unbusinesslike  customer  to  draw  upon  the  bank  for 


THE  NATURE  OF  COMMERCIAL  BANKING       17 

a  sum  in  excess  of  his  balance,  is  a  form  of  loan,  an 
asset,  but  generally  bears  no  interest.  Short  and 
Company  having  a  deposit  balance  of  $200  at  the  bank 
send  a  check  for  $210  to  a  New  York  wholesaler  in 
order  to  pay  an  overdue  bill.  The  check  is  deposited 
by  the  wholesaler  in  a  New  York  bank,  passes  through 
the  clearing  house  to  the  New  York  correspondent  of 
the  local  bank,  and  then  to  the  local  bank  itself  on 
which  it  is  drawn.  The  procedure  makes  several 
changes  in  the  balance  sheet.  Deposits  are  reduced 
$200,  i.  e.,  Short  and  Company's  balance  is  entirely 
wiped  out;  an  overdraft  of  $10,  a  negative  deposit, 
expressed  in  red  ink  on  the  individual  ledger,  is  created ; 
''due  from  banks"  is  reduced  $210. 

The  bank  has  made  no  profit  on  the  transaction 
but  the  balance  sheet  presents  an  entirely  new  item, 
overdrafts. 

Assets  Liabilities 

Loans  and  Discounts. .  .  $  20,000    Capital $100,000 

Overdrafts 10    Undivided  Profits 300 

Due  from  Other  Banks .     44,790    Deposits 94,500 

Real  Estate 5,000 

Bonds 30,000 

Cash 95,000 


$194,800  $194,800 

A  traveling  representative  of  a  commercial  paper 
house  visits  the  bank,  which  buys,  after  investigation, 
one  note  of  $2,500  each  of  four  such  open-market 
borrowers  as  the  International  Harvester  Company 
and  the  Goodyear  Tire  and  Rubber  Company.     The 


18  BANK  CREDIT 

average  time  of  the  paper  bought  is  4  months,  the  rate 
6  per  cent,  and  the  discount  $200.  New  York  and 
Chicago  drafts,  drawn  for  a  total  of  $9,800,  are  given 
in  payment. 

Without  reproducing  the  statement  of  the  bank, 
we  may  indicate  the  changes  which  the  purchase  of  the 
paper  in  the  open  market  entailed.  Undivided  profits 
are  increased  $200;  loans  and  discounts  by  $10,000; 
due  from  other  banks  is  reduced  $9,800. 

A  farmer^  in  order  to  add  to  his  acreage,  bon^ows 
$5,000  from  the  bank,  giving  a  mortgage  on  real  estate 
as  security.  The  time  is  five  years  and  interest  at  6 
per  cent  is  made  payable  annually  but  not  in  advance. 
The  amount  of  the  loan  is  taken  by  the  borrower  in 
cash  and  paid  to  the  seller  of  the  land,  who  deposits  it 
in  a  bank  in  a  neighboring  town.  Cash  is  reduced 
$5,000  by  this  transaction;  loans  and  discounts,  in- 
creased by  $5,000. 

Another  customer  of  the  bank  pledges  stock  in  a 
local  corporation  as  security  for  a  loan  of  $10,000  for 
30  days  at  5  per  cent,  leaving  the  proceeds,  $9,958.33 — 
$10,000  less  the  discount  of  $41.67, — on  deposit.  Loans 
and  discounts  are  increased  $10,000;  deposits  are  in- 
creased $9,958.33  and  undivided  profits,  $41.67. 

Stationery  and  supplies  are  bought  at  a  cost  of  $65, 
an  expense  item  that  we  may  properly  deduct  from 
undivided  profits.    Cash  is  reduced  $65. 

A  customer  deposits  $500  in  cash,  and  takes,  in 
preference  to  a  checking  balance,  a  certificate  of 
deposit  bearing  4  per  cent  interest.  Cash  is  increased 
$500  and  a  new  item,  certificates  of  deposit,  for  the 
same  amount,  appears  among  the  liabilities. 


THE  NATURE  OF  COMMERCIAL  BANKING       19 

A  local  patron  of  a  Chicago  mail  order  house,  pays 
cash  for  a  Chicago  draft  for  $88.60,  for  the  issue  of 
which  the  bank  charges  ten  cents  exchange.  The 
draft  is  a  check  of  one  bank  upon  another.  The  small 
exchange  charge  is  a  form  of  undivided  profits.  The 
buyer  of  the  draft  pays  $88.70  in  cash,  which  includes 
the  small  charge  for  the  services  of  the  bank.  Cash 
is  increased  $88.70.  Due  from  other  banks  is  reduced 
by  $88.60  and  the  amount  of  the  exchange  charge,  ten 
cents,  is  added  to  undivided  profits. 

Furniture  and  fixtures,  previously  bought,  are  paid 
for  by  means  of  a  cashier's  check  for  $12,000.  Furni- 
ture and  fixtures  will  now  be  listed  among  the  assets 
of  the  balance  sheet  as  worth  $12,000,  and  a  new  item, 
cashier's  checks,  for  the  same  amount,  will  appear  as  a 
liability  as  long  as  the  check  is  outstanding. 

Foreseeing  the  possibility  of  making  a  profit  by 
doing  so,  the  directors  authorize  the  issue  of  $25,000 
in  notes,  and,  in  accordance  with  statute  requirements, 
forward  $25,000  in  United  States  bonds,  which  were  on 
hand,  to  the  United  States  Treasury  as  security.  As 
the  National  Bank  Act  also  requires  the  maintenance  of 
a  5  per  cent  redemption  fund  in  the  United  States 
Treasury,  the  cash  of  our  bank  will  suffer  a  reduction 
of  $1,250.  We  may  conveniently  suppose  that  the 
notes  are  passed  over  the  counter  of  the  bank  in  ex- 
change for  customers'  demand  notes  aggregating 
$25,000.  As  demand  notes  bear  interest,  as  distin- 
guished from  discount,  no  immediate  profit  will  arise 
from  putting  the  notes  into  circulation. 

The  condition  of  the  bank  now  will  be  reflected  by 
the  following  statement: 


20 


BANK  CREDIT 


Assets 

Loans  and  Discounts  $  70,000.00 

Overdrafts 10.00 

Real  Estate 5,000.00 

Furniture  and  Fixtures     1 2 ,000 .  00 

U.S.  Bonds 30,000.00 

Due  from  Other 

Banks 34,901.40 

Redemption  Fund . .  1 ,250 .  00 

Cash 89,273.70 


Liabilities 

Capital $100,000.00 

Undi^^ded 
Profits.  .$541.77 
Less  Ex- 
penses. .     65.00 

476.77 

Circulating  Notes. .  25,000.00 

Deposits 104,458.33 

Certificates  of  De- 
posit         500.00 

Cashier's  Checks.     12,000.00 


$242,435.10 


$242,435.10 


A  glance  at  the  statement  shows  that  cash  is  equal 
to  more  than  50  per  cent  of  the  demand  habilities.  A 
bank  management  eager  to  make  a  profitable  record 
for  its  shareholders  will  be  prompted  to  lend  until 
demand  habilities,  of  which  individual  deposits  are  the 
main  item,  are  from  four  to  twenty  times  the  cash 
or  reserve. 

Expansion  of  Loans  a  Prelude  to  Loss  of  Cash 

Now  as  loans  increase,  in  the  case  of  an  individual 
bank,  cash  tends  to  diminish.  This  is  true  partly  be- 
cause a  few  borrowers  take  all  or  part  of  the  proceeds 
of  their  loans  in  cash.  An  attempt  on  the  part  of  an 
individual  bank  to  expand  its  loans  is  normally  met  by 
an  immediate  and  positive  reduction  of  its  cash.  The 
immediate  contraction  of  cash  is,  however,  almost 
neghgibly  small  and  is  not  the  only  restraining  force 
affecting  the  execution  of  a  hberal  loan  pohcy. 

A  second  check  on  the  loan  expansion  of  an  Individ- 


THE  NATURE  OF  COMMERCIAL  BANKING       21 

ual  bank  consists  in  the  fact  that  loans  result  in  an  in- 
crease in  deposits,  and  as  deposits  increase  a  given 
reserve  becomes  less  and  less  adequate  to  sustain 
their  growing  volume.  Moreover,  when  the  proceeds 
of  loans  are  left  on  deposit  with  the  bank,  the  balances 
created  are  soon  reduced — funds  are  borrowed  to  be 
used — through  checks  drawTi  by  the  borrowers  in 
connection  with  the  payment  of  current  obhgations. 
Such  checks  are  in  most  cases  remitted  to  creditors 
who  are  not  depositor-customers  of  the  drawers' 
bank,  which  stands  to  lose  cash  when  the  checks  are 
presented,  directly  or  indirectly,  for  payment.  As  the 
deposit  structure,  i,  e.,  liabilities  payable  in  cash  on 
demand  or  at  short  notice,  rises  as  a  result  of  rising 
loans,  the  cash  base  on  which  it  rests  becomes  smaller 
and  smaller.  The  liberal  loan  policy  of  an  individual 
bank  is  opposed,  then,  in  the  process  of  its  execution, 
by  a  double  check :  as  loans  are  extended  (a)  cash  tends 
to  diminish;  and  (b)  deposit  liabilities  arising  from 
loans  tend  to  swell, — the  prelude  to  a  further  loss  of 
cash. 

A  bank  whose  reserve  is  large  in  relation  to  its  de- 
posits or  demand  liabilities,  as  is  true  of  the  institution 
that  we  have  been  building  up,  will  continue  to  ex- 
pand its  loans  until,  through  a  slight  increase  of  de- 
posits arising  from  loans  and  the  decrease  of  cash 
resulting  from  loans,  the  ratio  of  reserve  to  deposit 
liabihties  becomes  what  the  bank  management  regards 
as  normal  or  desirable. 

If  the  institution  whose  operations  we  have  been 
handling  were  to  continue  to  expand  its  loan  and  other 
activities  until  it  became  representative  of  our  national 


22  BANK  CREDIT 

banks,  its  balance  sheet  would  present  an  appearance 
about  as  follows: 

Assets  Liabilities 

Loans  and  Discounts  $540,760.28  Capital  Stock $100,000.00 

Overdrafts 120. 16  Surplus 50,000.00 

U.  S.  Bonds 50,000 .  00  Undivided  Profits. . .     13,271 .  19 

Other  Bonds 20,200 .  00  Circulating  Notes .  .      12,500 .  00 

1  Stock  of  Federal  Individual  Deposits.  504,365 .  58 

Reserve  Bank 4,500 .  00  U.  S.  Deposits 2,961 .  75 

Real  Estate,  Fumi-  Bills  Rediscounted. .       5,000 .  00 

ture  and  Fixtures. .  25,899.50  Due  to  Other  Banks.     74,328.15 
Other  Assets 40,800.26  Certificates  of  De- 
Redemption  Fund  posit 18,441 .  37 

and  Due  from  U.  S.  Cashier's  Checks ...          468 .  00 

Treasurer  1,250.20 
Due  from  Other 

Banks 80,126.94 

Cash 17,678.70 


$781,336.04  $781,336.04 

Protective  Liabilities 

As  our  bank  has  grown,  one  new  and  somewhat 
puzzling  item  has  made  its  appearance  in  the  balance 
sheet,  namely,  surplus.  Bank  surplus  is  a  liability  of 
the  bank  to  its  shareholders  which  arises  from  and 
represents  the  excess  value  of  assets  over  and  above 
that  required  to  meet  all  other  liabilities,  including 
capital  stock  and  undivided  profits.  Surplus  differs 
from  capital  or  capital  stock  in  not  being  represented 
by  stock  certificates,  although  the  magnitude  of  the 

1  Federal  Reserve  banks  are  banker's  banks  owned  by  national 
banks,  state  banks,  and  trust  companies. 


THE  NATURE  OF  COMMERCIAL  BANKING       23 

surplus  tends  to  be  reflected  in  the  market  value  of  the 
relative  stock  certificates.  Surplus  also  differs  from 
capital  in  that  it  is  commonly  earned,  whereas  capital 
is  commonly  paid  in  by  the  shareholders.  Bank  sur- 
plus differs  from  the  surplus  of  most  business  corpora- 
tions in  that  it  is  sometimes,  not  infrequently,  ''paid 
in,"  wholly  or  in  part. 

Perhaps  the  most  important  difference  between 
capital  and  surplus  is  a  legal  one.  Double  liability 
attaches  to  the  ownership  of  stock  in  all  our  national 
banks  (except  the  National  Bank  of  Commerce  of  New 
York)  and  in  many  state  banks,  but  in  no  case  does  it 
apply  to  surplus. 

Reduced  to  simple  terms,  "double  liability"  means 
that  a  shareholder's  maximum  loss  in  connection  with 
the  holding  of  stock  can  not  legally  be  made  to  exceed 
the  amount  of  his  investment  (or  the  investment  and 
an  amount  sufficient  to  make  his  shares  fully  paid,  if 
the  stock  has  not  been  fully  paid)  plus  an  amount 
equal  to  the  par  value  of  his  stock.  In  general,  a  bank 
shareholder  may  be  called  upon,  in  the  event  of  heavy 
loss  or  disaster  to  his  bank,  for  a  contribution  in  addi- 
tion to  the  purchase  price  of  his  stock,  proportionate  to 
his  shares  held,  but  not  in  excess  of  their  par  value. 
Such  an  arrangement,  while  affording  a  reasonable 
degree  of  security  to  depositors  and  other  creditors, 
does  not  render  the  ownership  of  bank  stock  objection- 
able to  men  of  great  means  and  substance  as  did  at  one 
time  the  provisions  of  English  banking  law. 

Serious  bank  failures  in  the  United  Kingdom  in  the 
eighteen  hundred  and  seventies  spread  circles  of  ruin 
among  bank  shareholders,  who  were  Uable  on  their 


24  BANK  CREDIT 

bank  stocks  to  the  full  extent  of  their  fortunes.  Men 
shunned  the  latency  of  limitless  debt,  which  "appalls 
the  imagination  and  breaks  the  heart  of  effort,"  and  the 
ownership  of  banks  in  the  United  Kingdom  was  rapidly- 
passing  from  those  who  had  much  to  lose  to  those  who 
had  little  when  the  Act  of  1879  was  passed  to  prevent 
''the  defection  of  the  strong  and  the  infusion  of  the 
weak."  ^  The  act,  which  legalized  the  principle  of  re- 
serve liabihty,  was  accepted  before  1885  by  all  but 
seven  of  the  eighty-two  unlimited  banks  in  the  three 
Kingdoms.  The  act  enabled  every  bank  registered 
under  its  provisions  to  increase  the  nominal  value  of 
each  of  its  shares,  and  thus  to  enlarge  its  subscribed 
capital  without  increasing  the  amount  paid  up.  It  was 
further  provided  by  the  act  that  every  bank  that 
should  register  under  it  might  place  the  whole  or  any 
portion  of  its  uncalled  capital  in  the  form  of  reserve 
Hability.  Thus  the  liability  of  the  shareholders  of 
the  London  Joint  Stock  Bank,  prior  to  its  recent 
amalgamation  with  the  London  City  and  Midland 
Bank,  was  £85  per  share  in  addition  to  £15  paid 
thereon.  2 

While  the  Enghsh  system  of  reserve  liability  serves 
the  same  protective  purpose  as  the  double  liabihty 
feature  of  our  national  bank  stock,  it  is  flexible  and 
adaptable  to  the  varying  desires  and  views  of  share- 

^  George  Rae,  The  Country  Banker,  John  Murray,  London,  1885, 
p.  253. 

2  Interviews  on  the  Banking  and  Currency  Systems  of  England, 
Scotland,  France,  Germany,  Switzerland,  and  Italy,  Publications  of 
the  National  Monetary  Commission,  Senate  Document  No.  492, 
61st  Congress,  2nd  Session,  p.  60. 


THE  NATURE  OF  COMMERCIAL  BANKING       25 

holders  and  managements  having  widely  different 
temperaments  and  pohcies.  The  EngHsh  bank  manage- 
ment is  able  to  regulate  the  security  underlying  the 
ultimate  pajrment  of  deposits  and  other  creditor  liabili- 
ties through  the  reserve  liability  as  well  as  through  the 
payment  of  capital  and  the  accumulation  of  surplus, 
which  the  English  call  reserve. 

Surplus  and  undivided  profits  are  of  essentially 
the  same  nature.  Each  indicates  that  an  excess  value 
of  resources  exists  on  the  assets  side  of  the  balance 
sheet.  Surplus  almost  invariably  stands  as  a  round 
sum,  and  although  sometimes  owing  its  origin,  like 
capital,  to  cash  paid  in  by  the  shareholders,  very  fre- 
quently represents  the  accumulated  earnings  of  the 
bank.  The  undivided  profits  item  represents  the 
accumulatmg'  earnings  of  the  bank  and  is  scarcely  ever 
a  clean,  round  sum.  Undivided  profits  feed  surplus. 
At  intervals,  the  bookkeeper  of  a  prosperous  bank 
acting  at  the  behest  of  the  bank  management  will 
transfer  a  portion  of  undivided  profits,  $5,000,  $10,000, 
or  more,  to  surplus.  Dividends,  the  expenses  of  the 
bank,  and  most  losses  come  out  of  undivided  profits, 
whereas  surplus,  like  capital,  stands  as  a  buffer  be- 
tween the  creditors  of  the  bank  and  exceptionally 
heavy  losses. 

It  needs  to  be  emphasized  that  surplus,  like  capital 
stock  and  undivided  profits,  is  not  something  tangible 
that  the  bank  examiner  can  place  his  hands  on.  Like 
all  items  on  the  liabilities  side,  surplus  is  a  statement  of 
debt.  The  assets  available  to  cancel  the  debt  repre- 
sented by  surplus,  undivided  profits,  and  all  the  re- 
maining liabilities  are  listed  in  the  opposite  column  of 


26  BANK  CREDIT 

the  balance  sheet.  It  is  an  egregious  mistake  to  think 
of  the  surplus  or  capital  stock  or  undivided  profits  as 
being  normally  invested  in  any  one  asset  item  or  in  any 
particular  group  of  asset  items.  That  such  is  not  the 
case  will  be  clear  from  an  extreme,  but  legitimate, 
illustration.  A  bank  has  a  surplus  of  S50,000  and  cash 
of  S40,000.  If,  as  the  result  of  a  "run"  on  the  bank,  its 
cash  were  entirely  withdrawn,  deposits  would  be  re- 
duced $40,000  and  cash  reduced  $40,000,  with  no 
change  in  the  amount  of  the  surplus.  Any  other  item 
on  the  assets  side  of  the  financial  statement  might  be 
eliminated  in  a  similar  way  with  similar  results,  in  that 
surplus  would  be  left  undisturbed.  Demonstrably, 
surplus  does  not  stand  for  any  one  asset  item,  or 
even  group  of  items,  in  the  balance  sheet.  The  share- 
holders have  an  equity  in  each  of  the  resource 
items. 

Writers  on  banking  are  probably  responsible  in  no 
small  measure  for  the  general  lack  of  clarity  of  under- 
standing in  connection  with  the  nature  and  functions 
of  surplus.  Text  books  commonly  in  use  either  omit 
definition  and  explanation  of  surplus  or  fail  to  give  a 
clear  and  satisfying  exposition  of  this  mystifying  mag- 
nitude. 

Scott  says  with  reference  to  capital  and  surplus: 

By  the  former  is  meant  a  fund  contributed  directly  or 
guaranteed  by  the  stockholders  or  proprietors,  and  by  the 
latter  an  additional  fund  accumulated  from  profits.  ...  In 
case  of  failure,  such  funds  are  available  for  the  pa3Tnent  of 
depositors  and  noteholders  and  other  creditors,  who  are  to 
this  extent  guaranteed  against  loss.  Surplus  funds  may  also 
be  accumulated  as  a  means  of  meeting  temporary  losses  with- 


THE  NATURE  OF  COMMERCIAL  BANKING      27 

out  infringing  upon  the  other  resources  of  the  bank,  and  for 
the  equalization  of  dividends.^ 

Capital  and  surplus  are  represented  as  funds.  The 
practice  of  so  representing  surplus  and  capital  may 
have  been  prompted  by  the  following  provision  (section 
5199)  of  the  National  Bank  Act: 

The  directors  of  any  association  may,  semi-annually,  de- 
clare a  dividend  of  so  much  of  the  net  profits  of  the  association 
as  they  shall  judge  expedient  but  each  association  shall, 
before  the  declaration  of  a  dividend,  carry  one-tenth  part 
of  its  net  profits  of  the  preceding  half  year  to  its  surplus  fund 
until  the  same  shall  amount  to  twenty  per  centum  of  its 
capital  stock. 

White  refers  to  both  capital  and  surplus  in  terms  of  a 
guarantee  fund. 

The  capital  of  a  bank  is  primarily  a  guarantee  fund  con- 
tributed by  the  shareholders  to  give  it  stability  and  to  create 
confidence  in  its  soundness.  .  .  .  The  surplus  is  a  portion  of 
the  bank's  profits  not  divided  among  the  shareholders  but 
sat  aside  as  a  permanent  addition  to  the  guarantee  fund.  .  .  . 
For  all  banking  purposes  the  surplus  becomes  an  integral 
part  of  the  capital.^ 

Writers  fresh  from  an  examination  of  the  surplus 
provisions  of  the  National  Bank  Act  have  naturally 
employed   its   unfortunate   terminology.     The   result 

'  William  A.  Scott,  Money  and  Banking,  Henry  Holt  &  Company, 
New  York,  1916,  p.  132. 

2  Horace  White,  Money  and  Banking,  Fourth  Edition,  Ginn  and 
Company,  Boston,  p.  214. 


28  BANK  CREDIT 

has  been  confusion  between  surplus  and  cash  or  reserve 
which,  in  a  strict  sense,  is  a  fund.  Our  frequent  use  of 
the  term  surplus  reserv^e,  i.  e.,  the  reserve  held  in  excess 
of  legal  requirements,  is  not  intended  to  sharpen  the 
distinction  cuiTent  between  surplus  and  reserve.  Sur- 
plus is  excess  asset-value  due  shareholders.  It  is 
dollars'  worth,  not  dollars. 

The  balance  sheet  or  financial  statement  last  given 
should  convey  the  fact  that  the  bank  represented 
would  be  able,  in  the  event  of  liquidajtion,  to  meet  in 
full  all  of  its  obligations  to  outside  creditors  and  have 
sufficient  funds  remaining  to  pay  shareholders  $163.27, 
that  is,  S100,000(capital)+$50,000(surplus)-h$13,271.19 
(undivided  profits)  di^dded  by  1000  (shares  of  stock), 
on  each  of  the  one  thousand  shares  outstanding. 

The  question  naturally  suggests  itself,  might  not 
the  loans  and  discounts  or  other  assets  prove  to  be 
worth  more  or  less  than  100  cents  on  the  dollar?  The 
question  involves  the  subject  of  valuation.  Although 
the  value  of  the  principal  assets  of  a  bank  is  free  from 
fluctuation  traceable  to  physical  change,  there  is, 
nevertheless,  occasion  for  re-valuation,  for  the  scaling 
down  or  WTiting  up  of  assets  from  time  to  time.  While 
loans  and  discounts,  which  correspond  roughly  to  a 
merchant's  stock  of  goods,  are  not  subject  to  physical 
deterioration,  they  do  frequently  include  paper  on 
which  the  face  value  cannot  be  reaUzed.  The  value 
of  bonds  and  other  secm'ities  fluctuates  constantly, 
and  caUs  for  more  or  less  frequent  value  adjustment. 
Furniture  and  fixtures  also  require  re- valuation  from 
time  to  time.  Real  estate  is  somewhat  unsteady  in 
value.     The  valuation  placed  on  all  these  items  will 


THE  NATURE  OF  COMMERCIAL  BANKING       2& 

deperid  appreciably  on  the  temperament  and  disposi- 
tion of  the  bank  management.  Where  conservatism 
in  valuation  prevails, — as  is  probably  true  generally  in 
banking,  in  contradistinction,  perhaps,  to  ordinary 
business  circles, — assets  are  likely  to  be  undervalued, 
and  the  actual  surplus  larger  than  the  book  surplus. 
In  such  cases,  assets  are  ''concealed." 

Concealed  Assets  and  Liabilities 

Concealment  of  an  asset  commonly  represents  con- 
cealment of  profits  and,  whether  partial  or  complete, 
may  be  accomplished  in  several  ways.  Securities  that 
had  not  been  hsted  among  the  assets  and  amounting 
to  two  and  a  quarter  million  dollars  were  uncovered  by 
bank  examiners  at  work  on  the  affairs  of  a  New  York 
City  bank.  The  officers  of  the  bank  were  made  to 
show  the  two  and  a  quarter  million  dollars  in  their 
assets,  ''but  in  spite  of  that,  shortly  afterwards  they 
increased  their  capital  from  one  million  to  three  mil- 
lions without  the  stockholders  paying  in  a  cent  or  re- 
ducing their  surplus  or  undivided  profits.  So  they 
must  have  had  a  bunch  somewhere  that  we  did  not 
know  about."  Under  the  old  National  Bank  Act  real 
estate  could  not  be  acquired  and  held  beyond  a  certain 
time.  A  certain  bank  acquired  a  piece  of  real  estate 
and  not  wanting  "to  be  punched  up  by  an  examiner 
every  day"  the  management  "charged  the  entire  thing 
off"  and  let  it  go  at  that."  When  the  real  estate  was 
sold  later  the  money  was  thrown  back  into  the  profits 
of  the  bank.  It  has  happened  that  a  proportion  of 
hidden  assets  has  been  credited  to  each  of  the  difi'erent 
shareholders  of  a  bank  as  a  deposit,  under  an  agree- 


30  BAXK  CREDIT 

Dient  that  the  shareholders  miglit  not  draw  out  the 
amount  and  that  they  should  receive  no  interest 
thereon.^  Also,  di\-idends  have  not  been  declared,  by 
agreement  among  the  stockholders,  profits  being  con- 
cealed by  issuing  a  certificate  of  deposit  to  some  person 
as  trustee  for  the  stockholders. 

The  purpose  of  conceahng  assets  may  be  to  e\'ade 
taxation,  especially  when  capital  items  are  assessed 
at  a  higher  rate  than  real  estate  and  other  property. 
Again,  concealing  assets  may  discourage  competition. 
Large  profits  sho^s-n  might  induce  competition.  "Ulien 
profits  and  assets  are  concealed  from  some  of  the 
stockholders,  but  not  from  others,  the  practice  may  be 
resorted  to  in  order  that  ofiicers  or  directors  may  be 
able  to  buy  the  stock  of  the  ill  informed  shareholders 
at  less  than  its  value. - 

Liabilities  are  also  frequently  concealed, — a  practice 
that  is  even  more  seriously  objectionable  than  that  of 
concealing  assets.  Liabilities  are  generally  concealed 
by  dishonest  and  designing  ofiicers  or  employees  in 
order  to  offset  a  shortage  in  the  cash. 

It  is  assumed  in  our  discussion  of  surplus  and  its 
role  in  commercial  banking  that  book  curplus  ac- 
curatel}^  reflects  actual  surplus.  However,  it  must 
be  borne  in  mind  that  whether  that  reflection  or 
measurement  is  accurate  or  not  depends  upon  the  val- 
uation of  the  multifarious  itenos  that  are  embraced 
in  the  aggregates  vdth  which  the  balance  sheet  deals. 

If  we  assume  that  the  valuation  of  the  assets  in  the 

1  Proceedings,  Ninth  Annual  Convention,  National  Association  of 
Supenisors  of  State  Banks,  1910,  pp.  57-59. 
*  Op.  cit.,  pp.  56,  57. 


THE  NATURE  OF  COMMERCIAL  BANKING       31 

financial  statement  on  page  22  is  correct,  it  will  be 
evident  that  the  bank  represented  could  sustain  a  loss 
of  $163,271.19  and  still  pay  its  creditors  in  full,  without 
levying  an  assessment  on  the  shareholders  in  connec- 
tion with  the  liabiHty  for  the  amount  of  the  face  value 
of  their  stock.  If  the  bank  had  not  built  up  a  surplus 
and,  instead  of  so  doing,  had  paid  di\ddends  sufficiently 
liberal  to  absorb  the  earnings,  any  loss  in  excess  of 
$113,271.19  (or  of  $213,271.19,  if  we  include  the  possible 
levy  upon  stockholders  pro\dded  for  by  the  double 
HabiHty  feature  of  the  National  Bank  Act)  would  cut 
into  the  amount  available  for  meeting  obligations  to 
the  creditors  of  the  bank.  The  larger  the  capital,  sur- 
plus or  undi\ided  profits,  other  things  being  equal,  the 
less  is  the  likelihood  of  loss  to  the  creditors  of  the  bank. 
Or  stating  the  same  fact  in  other  words,  the  larger  the 
surplus  or  other  liabihties  to  the  shareholders,  the 
greater  is  the  loss  that  a  bank  can  sustain  and  still  pay 
its  deposits  and  other  creditor  liabilities  in  full. 


CHAPTER  III 
The  Philosophy  of  Bank  Credit 

The  prime  purpose  of  the  present  chapter  will  be  to 
draw  a  sharp  Une  of  distinction  between  credit  ex- 
tension by  an  individual  bank  and  that  of  banks  taken 
in  the  aggregate.  The  accepted  statements  of  banking 
theory,  with  scarcely  an  exception,^  have  made  no 
such  distinction,  with  the  result  that  confusion,  ob- 
scurity, and  error  prevail  with  reference  to  the  most 
fimdamental  principles  of  the  subject.  The  explana- 
tion of  the  way  in  which  banking  institutions  manufac- 
ture credit,  i.  e.,  make  loans  equal  to  several  times  the 
amount  of  their  cash  holdings,  has  been  essayed  again 
and  again,  but  the  traditional  treatment  appears  to  be 
marked  by  lack  of  insight  into  the  heart  of  the  prob- 
lem, and  the  subject  seems  still  to  stand  in  need  of 
exposition. 

The  influence  of  bankers'  banks  on  the  manufacture 
of  bank  credit  being  taken  up  in  chapter  VI,  it  is  in 
place  to  say  that  throughout  this  chapter  cash  is  used 
in  a  broad  sense  synonymously  with  reserve,  and  no 
distinction  is  made  between  checks,  drafts,  etc.,  that 
are  convertible  into  cash  upon  presentation  and  cash 
itself.    It  makes  no  substantial  difference  to  the  banker 

1  Professor  H.  J.  Davenport  gives  a  fragmentary  view  of  the 
theory  here  developed.  See  his  Economics  of  Enterprise,  The  Mac- 
miUan  Company,  New  York,  1913,  pp.  263,  286,  287. 

32 


THE  PHILOSOPHY  OF  BANK  CREDIT  33 

whether  additions  to  his  volume  of  deposits  have  their 
origin  in  the  receipt  of  lawful  money  or  in  the  form  of 
various  credit  instruments,  bank  notes,  checks,  drafts, 
that  are  readily  exchangeable  for  or  convertible  into 
lawful  money. 

It  has  long  been  observed  that  the  banks  of  a  given 
credit  area,  e.  g.,  United  States,  are  able  to  extend 
credit,  i.  e.,  make  loans,  equal  to  several  times  their 
reserve  and  the  inference  has  been  made  that  what  is 
true  of  all  banks  taken  in  the  aggregate  is  true  of  each ; 
and  the  inference  has  been  supported  by  the  observed 
fact  that  the  balance  sheet  of  any  representative  in- 
dividual bank  carries  loans  several  times  the  amount 
of  the  reserve  held.  Observing  that  an  individual  bank, 
as  well  as  banks  taken  collectively,  commonly  has 
loans  equal  to  several  times  the  reserve,  the  theorist 
has  reasoned  that  a  given  addition  to  the  reserves  of  an 
individual  bank  would  place  the  receiving  institution 
in  a  position  to  make  a  manifold  increase  in  its  ow7i 
loans.  If  a  bank  holding  cash  of  $100,000  has  loans 
outstanding  equal  to  $1,000,000,  the  receipt  of  another 
$100,000  in  cash,  the  old  theoiy  runs,  would  enable  the 
bank  to  add  another  $1,000,000  to  its  loan  item.^  Such 
reasoning,  however,  leaves  out  of  account  certain  con- 
sequences of  loan  expansion  to  which  attention  will 
be  directed  later  in  this  chapter,  and  we  may  now  state, 
as  a  thesis  to  be  defended,  that  the  acquisition  of  ad- 

1  See  E.  E.  Agger,  Organized  Banking,  Henry  Holt  &  Company, 
New  York,  1918,  pp.  31-33;  H.  G.  Moulton,  Surplus  in  Commercial 
Banking,  Journal  of  Political  Economy,  Vol.  XXV,  December,  1917, 
pp.  1007-1009;  W.  H.  Kniffin,  The  Practical  Work  of  a  Bank,  Bank- 
ers' Publishing  Company,  New  York,  1915,  pp.  14-16. 


34  BANK  CREDIT 

ditional  primary  deposits  enables  an  individual  bank 
to  expand  its  loan  item  by  little  more  than  the  amount  of 
such  deposits.^  But  how  can  a  given  amount  of  cash 
become  the  basis  of  manifold  loans  and  deposits  in  a 
banking  system  if  the  acquisition  of  that  amount  by  an 
indi\'idual  bank  has  little  or  no  multiplicative  impor- 
tance? That  is  the  riddle  of  banking  and  to  its  solution 
this  chapter  is  chiefly  devoted.  A  statement  and  critical 
exposition  of  the  time-honored  theory,  handed  down 
consistently  from  the  days  of  Alexander  Hamilton  to 
the  present,  will  serve  as  an  advantageous  point  of  de- 
parture. 

A  Critical  Analysis  of  the  Traditional  Theory 

Horace  "VNTiite,  who  follows  Macleod,  has  employed 
substantially  the  same  explanation  in  the  various  edi- 
tions of  his  Money  and  Banking,  widely  used  as  a  text 
in  our  colleges  and  universities.  The  following  pas- 
sages from  that  work  are  typical  of  the  traditional 
treatment. 

An  analysis  of  modern  banking  is  substantially  this :  A  man 
has  $10,000  of  his  own  money.  He  starts  a  bank.  His 
neighbors  deposit  $50,000  with  him.  .  .  .  The  banker  finds 
by  experience  that  some  of  his  customers  will  bring  in  as 
much  money  as  others  draw  out,  so  that  $60,000  is  on  hand 
all  the  time.    He  infers  that  if  his  own  $10,000,  in  connection 

1  A  primary  deposit  is  one  growing  out  of  the  lodgment  of  cash 
or  its  equivalent,  and  not  out  of  credit  extended  by  the  bank  in 
question.  A  fuller  statement  of  the  nature  of  primary  deposits  as 
distinguished  from  derivative  deposits,  which  have  their  origin  in 
loans  extended  to  depositors,  is  given  in  later  pages  of  this  chapter. 


THE  PHILOSOPHY  OF  BANK  CREDIT  35 

with  his  good  reputation,  is  considered  by  the  public  a 
guarantee  for  $50,000,  then  the  whole  $60,000  will  serve  as  a 
guarantee  for  a  much  larger  sum.  When  he  begins,  his 
balance  sheet  reads  in  this  way: 

Resources  Liabilities 

Cash $60,000    Capital $10,000 

Deposits 50,000 


$60,000  $60,000 

The  banker  now  begins  to  buy  promissory  notes,  or  bills  of 
exchange,  due  at  a  specified  time  in  the  future,  paying  the 
face  value  of  the  same,  minus  interest  at  a  certain  rate  for  the 
intervening  time.  This  is  called  discounting  commercial 
paper.  When  he  discounts  for  one  of  his  customers  a  note  for 
$1,000  running  ninety  days,  he  deducts  the  interest  (say  $15), 
entering  the  amount  under  the  head  of  profits  due  to  stock- 
holders, and  writes  the  remainder,  $985,  on  the  credit  side  of 
the  customer's  pass  book,  entering  a  corresponding  sum  as  a 
credit  to  that  person's  account  in  his  own  books.  This 
credit  is  called  a  deposit,  and  properly  so,  since  the  net  pur- 
port of  the  transaction  is  that  the  banker  has  bought  an 
interest-bearing  security  and  the  seller  has  deposited  the 
money  he  received  for  it  in  the  bank,  to  be  drawn  out  at  his 
pleasure.  If  the  customer  had  deposited  $1,000  gold  simulta- 
neously with  the  foregoing  transaction,  his  total  deposits 
would  have  been  $1,985.  Yet  there  is  a  difference  between 
the  two  kinds  of  deposits,  the  one  being  of  money  and  the 
other  a  bank  credit.  In  practice,  the  bank  credits  at  any 
given  time  may  be  four  or  five  times  as  large  as  the  amount 
of  cash  in  the  bank. 

The  process  of  discounting  commercial  paper  continues 
until  the  banker  has  $200,000  of  bills  receivable  in  his  port- 
folio.   Then  his  account  stands  thus: 


36  BANK  CREDIT 

Resources  Liabilities 

Cash S  60,000    Deposits $247,000 

Loans  and  Discounts. . .  200,000    Capital 10,000 

Profit 3,000 


$260,000  $260,000 

Thus  the  business  venture  called  a  "bank"  owes  to  de- 
positors and  to  the  banker  himself  S260,000;  and  it  has  assets 
which  will  produce  that  amount,  but  only  $60,000  of  it  is 
cash.  It  follows  that  the  banker  has  manufactured  some- 
thing which  serves  as  a  medium  of  exchange  to  the  extent  of 
S197,000.  This  is  credit.  Goods  can  usually  be  bought  and 
sold  with  it  as  readily  as  with  money,  since  checks  drawn 
against  deposits  are  accepted  in  trade  by  the  whole  com- 
munity. The  whole  $200,000  of  bills  are  not  discounted  at 
one  time,  but  gradually,  so  that  some  are  always  maturing 
and  bringing  in  money  to  meet  the  banker's  liabilities.^ 

Tw^o  questions  arise  at  once  concerning  the  explana- 
tion given.  The  first  is,  would  not  unfavorable  clear- 
ing house  balances  preclude  the  possibility  of  the 
bank  considered  lending  $200,000  on  the  basis  of  $60,- 
000  in  money?  The  second  question  is,  would  the 
gradual  extension  of  loans  of  the  bank  enable  the 
institution,  without  receiving  additional  primary  cash 
deposits, — additional  primary  deposits,  according  to 
the  traditional  theory,  would  also  serve  to  support 
manifold  loans — to  lend  $200,000  on  the  basis  of  an 
undiminished  reserve  of  $60,000? 

The  second  question,  relating  to  the  content  of  the 

1  Horace  White,  Money  and  Banking,  Fifth  Edition,  Ginn  & 
Company,  Boston,  1914,  pp.  194-196. 


THE  PHILOSOPHY  OF  BANK  CREDIT  37 

last  sentence  quoted  above,  may  be  disposed  of  at 
once.  The  error  there  involved  is  that  small  loans 
made  today,  January  1,  will  when  they  mature,  April 
1,  bring  in  money  with  which  to  meet  the  banker's 
liabilities  arising  from  heavier  loans  made  April  1.  If 
the  funds  received  from  the  repayment  of  the  early 
loans  are  sufficient  to  meet  the  banker's  habilities 
arising  from  the  heavier  loans  made  April  1,  the  funds 
first  loaned  would  be  sufficient  to  do  the  same.^  In 
other  words,  if  loans  amounting  to  $200,000  could  be 
extended  gradually  on  the  basis  of  $60,000  cash,  the 
same  amount  could  be  loaned  at  once.  But  the  result 
of  a  loan  expansion  of  the  bank  would  be  a  loss  of  cash 
through  unfavorable  clearing  house  balances  as  the 
sequel  will  show. 

Let  us  suppose  that  the  Hanover  National  Bank  of 
New  York  acquires  a  deposit  of  $1,000,000  in  gold  im- 
ported and  lends  $10,000,000  to  its  customers,  an 
amount  suggested  by  the  approximate  ratio  of  1  to  10 
between  reserves  and  deposits  in  our  banking  system 
at  the  present  time.  (The  ratio  of  cash  to  deposits, 
one  to  four,  in  the  statement  quoted  from  White,  which 
was  taken  almost  verbatim  from  Macleod's  work  of  a 
half  century  ago,^  is  supposed  to  represent  the  ratio 
customary  at  that  time.)  The  borrowing  customers  of 
the  Hanover  National  Bank  would  withdraw  little  or 

*  It  is  true  that  a  small  proportion  of  loans  is  customarily  held  on 
deposit  by  the  borrower  with  the  lending  banker  and  that,  as  a  re- 
sult, the  lending  bank  is  able  commonly  to  extend  credit  about  equal 
in  amount  to  "cash"  deposits  received. 

2  Henry  Dunning  Macleod,  Theory  and  Practice  of  Banking  (Fifth 
Edition),  Vol.  I,  p.  324. 


9  0  6  7  7 


38  BANK  CREDIT 

no  cash  over  the  counter  but  would  certainly  draw 
checks  against  the  proceeds  of  their  loans  deposited 
with  the  bank.  The  checks  would  be  sent  to  their 
creditors  in  New  York  and  elsewhere.  Checks  for  a 
relatively  small  amount  would  be  deposited  for  credit 
at  the  Hanover  National  Bank,  effecting  the  with- 
drawal of  no  cash;  but  the  great  bulk  of  the  checks 
drawn  by  the  borrowers  of  the  $10,000,000  against  the 
proceeds  of  their  loans  would  reach  the  Hanover 
National  Bank  via  the  New  York  clearing  house,  many 
ha\'ing  traveled  long  distances  from  the  points  of  de- 
posit. Perhaps  not  more  than  §100,000  out  of  all 
the  checks  drawn  against  the  S10,000,000  borrowed 
would  be  deposited  at  the  Hanover  National  Bank. 
The  remainder  of  the  manifold  loans  supposedly  ex- 
tended on  the  basis  of  the  imported  gold  deposited, 
except  a  small  proportion,  probably  not  more  than  20 
per  cent,  not  checked  by  borrowers,  would  represent 
cash  that  the  bank  would  lose  through  unfavorable 
clearing  house  balances,  an  amoimt  that  would  be 
scattered  widely  among  the  banks  of  the  system.  It 
is  clear  that  an  indi\adual  bank  attempting  to  lend 
greatly  in  excess  of  the  amount  of  an  addition  to  its 
reserves  would  do  so  at  its  peril. 

Loan  and  Deposit  Expansion  within  the  Banking  System 

It  would  be  equally  clear,  however,  if  there  were  only 
one  bank  into  which  all  of  our  bank:s  were  merged, 
doing  the  loan  and  deposit  business  of  the  entire 
country  and  maintaining  a  reserve-deposit  ratio  of  R, 
that  the  net  deposit  of  a  given  amount  of  cash  or  re- 


THE  PHILOSOPHY  OF  BANK  CREDIT  39 

serve,  c,  would  enable  the  institution  to  lend,  in  addi- 
tion to  its  normal  amount  of  loans  outstanding, 

1  ,       _  .        c 
P  (c  —  Re)  or  :p  —  c 

This  is  true  because  the  deposit  arising  from  the  cash, 
c,  would  itself  call  for  a  reserve  equal  to  Re,  leaving 
c-Rc  as  reserve  for  deposits  arising  from  additional 
loans.  The  amalgamated  bank,  i.  e.,  the  banking  sys- 
tem, would  tend  to  lose  no  cash  as  a  result  of  its  loan 
expansion,  because  all  checks  drawn  by  borrowers  would 
be  in  favor  of  depositors  of  the  drawers'  bank,  who 
would  themselves  place  the  checks  on  deposit.^  The 
total  deposits  expansion  for  the  banking  system,  under 

1  c 

the  conditions  stated,  would  be  -^^c  or  — . 

R  R 

If  the  expansion  of  deposits  were  either  more  or  less 

c 

than  :^,  there  would  be  involved,  obviously,  a  departure 
R 

from  the  cash-deposits  ratio  previously  existent  in  the 

banking  system. 

Let  the  ratio  of  cash  to  deposits  for  the  banking 

system,  then,  be  represented  by  R,  the  new  cash  or 

reserve,  by  c,  the  expansion  of  deposits  traceable  to  an 

addition  to  cash,  by  D,  the  loan  expansion  arising  from 

the  same  source,  by  X,  and  the  following  equations 

stand  forth: 

R  R 

^  Some  cash  might  be  lost  as  a  result  of  rising  prices  and  a  con- 
sequent increased  demand  for  hand  to  hand  money. 


40  BANK  CREDIT 

We  have  seen  that  the  loan  expansion  in  an  iso- 
lated bank  or  in  the  hanking  system,  as  the  result  of  the 
acquisition  of  a  given  amount  of  resei-ve,  is  several 
times  greater  than  the  loan  expansion  practicable  for 
an  indi\'idual  bank  acquiring  the  same  amount.  What 
is  true  for  the  banking  system  as  an  aggregate  is  not 
true  for  an  individual  bank  that  constitutes  only  one 
of  many  units  in  that  aggregate.  The  sudden  acquisi- 
tion of  a  substantial  amount  of  reserve  by  a  representa- 
tive indi\ddual  bank,  other  things  remaining  the  same, 
tends  to  cause  that  bank  to  become  out  of  tune  with 
the  banks  in  the  system  as  a  whole.  As  the  individual 
bank  increases  its  loans  in  order  to  re-establish  its 
normal  reserve-deposits  ratio,  reserve  is  lost  to  other 
banks  and  the  new  reserve,  split  into  small  fragments, 
becomes  dispersed  among  the  banks  of  the  system. 
Through  the  process  of  dispersion  it  comes  to  constitute 
the  basis  of  a  manifold  loan  expansion. 

Primary  and  Derivative  Deposits  Differentiated 

An  explanation  of  the  way  in  which  new  cash  or 
reserve  becomes  the  basis  of  a  manifold  and  wide  ex- 
tension of  loans  by  the  banks  of  a  system  may  be 
approached  by  distinguishing  carefully  between  what, 
for  lack  of  better  terms,  may  be  called  primary  and 
derivative  deposits.  A  primary  deposit  may  be  defined 
as  one  that  arises  from  the  actual  lodgment  in  a  bank 
of  cash  or  its  readily  convertible  equivalent  such  as" 
checks  and  drafts  drawn  on  other  banks,  but  not  made 
in  anticipation  of  the  repayment  of  a  loan.  By  a  deriv- 
ative deposit  is  meant  one  which  arises  directly  from 
a  loan  or  which  is  accumulated  by  a  borrower  in  antici- 


THE  PHILOSOPHY  OF  BANK  CREDIT  41 

pation  of  the  repayment  of  a  loan.  Whether  springing 
from  loan-proceeds  left  with  the  bank — which  will 
later  be  largely,  if  not  entirely,  drawn  out  by  check  to 
serve  the  purpose  for  which  the  loan  was  made — or 
arising  from  the  placement  of  funds  in  the  bank  in 
order  to  retire  a  loan  at  maturity,  a  derivative  deposit 
is  extremely  variable  in  magnitude.  A  primary  deposit, 
standing  as  it  does  for  funds  placed  in  the  bank  for 
safekeeping  and  to  be  currently  checked  against  as  well 
as  currently  replenished,  is  not  marked  by  the  extreme 
ups  and  downs  to  which  a  derivative  deposit  balance  is 
subject.  A  primary  deposit,  it  is  true,  may  be  large  to- 
day and  small  tomorrow,  but  there  is  a  strong  tendency 
toward  regularity  and  uniformity  of  volume.  The 
primary  deposit  balance  of  a  representative  business 
concern  moves  generally  within  pretty  definite  limits, 
the  lower  limit  never  reaching  zero.  A  derivative  de- 
posit, on  the  other  hand,  is  superimposed  upon  the 
primary  balance  and,  at  the  initial  date  of  the  relative 
loan,  rises  at  once  to  a  high  point,  falls  away  during  the 
early  period  of  the  loan,  then  as  the  loan-maturity 
approaches  rises  more  or  less  gradually  to  a  peak  and, 
when  the  loan  is  paid,  drops  precipitately  to  the  initial 
and  basic  level.  A  primary  deposit  balance  is  roughly 
analogous  to  a  flowing  stream  in  the  dry  season  of  the 
year.  A  derivative  deposit  is,  perhaps  even  more 
roughly,  analogous  to  the  added  and  quickly  changing 
volume  that  comes  with  the  rains  of  spring  and  fall. 
A  primary  deposit  tends,  then,  to  be  relatively  stable 
in  amount,  while  a  derivative  deposit,  always  "made" 
only  to  be  ''withdrawn,"  is  subject,  during  its  compara- 
tively short  and  limited  existence,  to  sharp  and  pro- 


42  BANK  CREDIT 

nounced  changes  in  magnitude.  The  nature  of  pri- 
mary deposits  is  easily  understood.  Derivative  de- 
posits, invariably  tied  closely  to  loans,  require  further 
explanation. 

A  tj'pical  bank  borrower  does  not  at  once  check  out 
the  entire  amount  borrowed  and,  furthermore,  for  a 
short  time  just  preceding  the  maturity  of  the  loan  he 
does  not  fail  to  accumulate  a  balance  sufficiently  large 
to  enable  him  to  retire  the  loan  at  maturity  by  means 
of  check.  Indeed  borrowers  are  required  by  many 
city  banks  to  maintain  an  average  balance  equal  to 
a  definite  percentage,  usually  20  per  cent,  of  the  maxi- 
mum credit  extended, — a  circumstance  that  tends  to 
prevent  the  withdrawal  of  the  entire  amount  borrowed. 
On  the  contrary,  many  country  bankers  affirm  that 
loans  made  to  a  depositor  have  nothing  to  do  with  his 
balance.  But  even  these  country  bankers  admit  that 
the  typical  borrower's  balance  is  swollen  for  a  few 
days  after  the  negotiation  of  the  loan,  before  checks, 
promptly  drawn  by  the  borrower,  return  to  his  bank, 
reducing  his  balance.  They  also  testify  that  the  bor- 
rower commonly  increases  his  balance  during  the 
late  days  of  the  loan  period,  which  may  be  lengthened 
by  renewal,  in  order  to  be  able  to  repay  his  loan  by 
check  at  maturity.  If  we  let  diagram  1  represent  a 
longitudinal  section  of  the  deposit  account  of  a  typical 
bank  borrower,  we  shall  be  able  to  see  the  relation 
between  an  individual  bank-loan  and  the  correspond- 
ing derivative  deposit  balance. 

Time  is  measured  and  registered  along  the  0  P  or 
horizontal  axis,  i.  e.,  by  distance  from  O  toward  the 
right.     The  amount  of  the  total  deposit  balance  of  a 


THE  PHILOSOPHY  OF  BANK  CREDIT 


43 


typical  depositor-borrower  is  measured  by  the  vertical 
distance  above  the  0  P  axis. 

Thus,  before  borrowing,  the  bank  customer,  whose 
account  is  pictured  in  the  diagram,  had  a  balance  of 
O  M.  Just  after  leaving  on  deposit  the  proceeds  of  a 
loan,  he  had  a  balance  of  0  M  plus  M'  K  of  which 
M'  K  was  "derivative."    Funds  are  borrowed  for  use, 


ionpcjcwr 


Diagram  1 


and  we  see  that  fact  reflected  in  the  downward  course 
of  the  curve  K  L  during  the  first  days  of  the  loan 
period. 

A  short  time  before  the  maturity  of  the  loan,  prep- 
aration is  made  by  the  borrower  looking  toward 
repayment,  and  as  time  passes  the  vertical  distance 
between  the  M  N  line  and  the  K  L  line  becomes 
greater.  Derivative  deposits  rise  in  anticipation  of 
the  maturity  of  the  loan,  reaching  a  maximum  on  that 
day.  When  the  loan  is  retired,  the  deposit  balance 
drops  to  the  level  obtaining  before  the  loan  was  se- 
cured. 

The  reader,  and  especially  the  practical  banker, 
who  objects  to  the  "ideal"  character  of  the  operations 


44  BANK  CREDIT 

represented  by  diagram  1,  as  invalidating  the  theory 
developed,  is  urged  to  peruse  the  exercises  and  prob- 
lems bearing  upon  this  chapter  given  in  Appendix  A. 

The  Ratio  of  Derivative  Deposits  to  Loans 

The  average  magnitude  of  the  derivative  deposit 
balance,  represented  by  the  average  height  of  the 
cur\'e  K  L  above  the  hne  M'N'  in  diagram  1,  in  re- 
lation to  the  amount  of  the  loan,  K  M',  varies  decid- 
edly from  bon'ower  to  borroY^er  and — less  markedly — 
from  bank  to  baiilv.  The  most  extreme  case  of  varia- 
tion that  the  writer  has  found  among  borrowers  is 
furnished  by  a  bank  at  Sioux  Falls,  South  Dakota.  The 
cashier's  own  words  are  interesting.  "Quite  a  percent- 
age of  our  business  is  done  with  farmers  who  at  most 
seasons  of  the  year  maintain  only  small  accounts  even 
though  their  borrowed  balance  is  a  good  sized  one. 
Then  too  at  the  other  extreme  we  have  had  a  few  cus- 
tomers who  borrowed  good  sized  amounts  and  left  a 
larger  amount  than  the  total  amount  borrowed  on  de- 
posit all  the  time  as  an  emergency  fund  in  case  of  a 
sudden  need.  These  are,  in  our  case,  men  who  deal  in 
real  estate,  owners,  not  brokers,  so  that  if  they  are  at  a 
distance  and  find  what  they  consider  a  snap  they  shall 
be  able  to  draw  their  check  without  stopping  to  nego- 
tiate for  a  loan." 

The  subjoined  table,  containing  estimates  obtained 
from  the  banks  represented,  throws  Ught  on  the  varia- 
tion of  the  ratio  from  bank  to  bank  and  shows  within 
what  hmits  the  average  or  typical  ratio  for  American 
banks  would  fall. 


THE  PHILOSOPHY  OF  BANK  CREDIT  45 

Location  of  Bank  Ratio  of  Derivative  Deposits  to  Loans 

Boston,  Mass 10  per  cent 

Salem,  Mass 20  "  " 

Rockport,  Mass 7.5  "  " 

Claremont,  N.  H 10  "  " 

Manchester,  N.  H 10  "  " 

Milford,  N.  H 10  "  " 

Newport,  N.  H.i 3  "  " 

New  York,  N.  Y 20  "  " 

Erie,  Pa.2 8  "  " 

Baltimore,  Md 10  "  " 

Tiffin,  Ohio 10  "  " 

Medina,  Ohio 20  "  " 

Elkhart,  Ind 8. 75  "  " 

Assumption,  111 12.5  "  " 

Carthage,  111 20  "  " 

Freeport,  111 5  "  " 

Galesburg,  111 20  "  " 

Frankfort,  Ky 10  "  " 

Scottsville,  Ky.3 10  "  " 

GreenviUe,  S.  C." 18.5  "  " 

^  Detailed  estimate  is  as  follows: 

10  per  cent  of  loans  result  in  an  average  balance  of  15  per  cent 
30  per  cent  of  loans  result  in  an  average  balance  of  5  per  cent 
60  per  cent  of  loans  result  in  an  average  balance  of  0  per  cent 
'  Sixty  per  cent  of  loans  are  "out  during  the  life  of  the  obligation; 
and  40  per  cent  perhaps  leave  20  per  cent  of  the  amount  borrowed 
with  us  during  the  loan  period." 
3  Detailed  estimate : 

10  per  cent  of  loans  result  in  an  average  balance  of  40  per  cent 

30  per  cent  of  loans  result  in  an  average  balance  of  20  per  cent 

60  per  cent  of  loans  result  in  an  average  balance  of    0  per  cent 

*  10  per  cent  of  loans  result  in  an  average  balance  of  40  per  cent 

20  per  cent  of  loans  result  in  an  average  balance  of  30  per  cent 

20  per  cent  of  loans  result  in  an  average  balance  of  20  per  cent 

40  per  cent  of  loans  result  in  an  average  balance  of  10  per  cent 

10  per  cent  of  loans  result  in  an  average  balance  of    5  per  cent 


4G  BANK  CREDIT 

Location  of  Bank  Ratio  of  Derivative  Deposits  to  Loans 

Morgan  City,  La 10  per  cent 

Corpus  Christi,  Tex 15 

Oskaloosa,  la 2  " 

Pierre,  S.D 5 

Denver,  Colo 10  " 

San  Francisco,  Cal.^ 10  " 

It  seems  safe  to  conclude  that  for  our  banks  taken 
in  the  aggregate  the  derivative  deposit-loan  ratio  lies 
somewhere  between  5  and  20  per  cent. 

Factors  Determining  the  Ratio  of  Derivative  Deposits 
to  Loans 

The  proportion  of  loans  left  on  deposit  is  a  function 
of  many  variables.  In  a  community  of  farmers  and 
stock  men,  relatively  small  derivative  deposits  would 
be  maintained  in  relation  to  bank  borrowings.  ''In  a 
strictly  farming  community,"  says  an  Illinois  banker, 
"loans  are  usually  made  for  a  definite  piu-pose,  such  as 
buying  stock  or  something  of  that  nature  and  then  paid 
off  when  grain  or  stock  is  sold  in  the  bulk."  It  is 
evident  that,  under  these  conditions,  deposits  traceable 
to  loans  during  the  hfe  of  the  obUgations  would  be 
small. 

When  a  high  rate  of  interest  is  charged,  especially 
to  farmers  and  stock  men  as  is  common  in  the  West, 
the  proportion  of  derivative  deposits  to  loans  may 

1  Estimate  of  writer,  based  on  information  furnished  by  three 
banks  of  San  Francisco, — where  banking  competition  is  very  keen 
and  requirements  as  to  balances  in  relation  to  loans  comparatively 
lax. 


THE  PHILOSOPHY  OF  BANK  CREDIT  47 

be  whittled  down  still  further.  The  higher  the  interest 
rate  charged  by  the  bank,  the  stronger  will  be  the  ten- 
dency for  the  borrower  to  make  the  inception  of  his 
loans  synchronize  with  the  initial  date  of  the  period  for 
which  he  needs  funds,  and  the  maturity  of  the  loans 
synchronize  with  sales  or  other  cash  receipts.  A  South 
Dakota  banker  estimates  that  a  typical  loan  made  by 
his  bank  is  practically  exhausted  the  day  that  it  is 
borrow^ed  and  that  very  little  deposit  is  made  until  the 
date  that  the  note  is  paid.  ''The  reason  for  this  is  as 
follows:  Our  rate  of  interest  is  high,  10  per  cent,  and 
when  a  customer  makes  a  loan  he  does  not  do  so  until 
he  has  inomediate  use  for  the  money  and  then  only 
borrows  what  he  really  needs.  Our  loans,"  he  con- 
tinues, ''are  mostly  made  to  stock  men  and  are  made 
payable  at  any  time  before  maturity,  so  that  usually 
the  loan  is  entirely  taken  up  from  the  proceeds  of 
stock  sales  on  the  day  the  sale  is  made,  or  that  the 
returns  are  received."  High  interest  charges  and 
meagre  derivative  deposits  go  hand  in  hand. 

Conversely,  where  interest  rates  are  comparatively 
low,  the  desire  of  business  men  to  maintain  balances 
satisfactory  to  their  bankers  asserts  itself  and  money 
may  be  borrowed  in  excess  of  actual  or  estimated 
needs.  The  good  business  man,  it  is  well  known,  is 
jealous  of  his  balance  in  his  own  bank.  On  general 
principles,  he  does  not  wish  to  see  his  balance  run  too 
low  and  he  frequently  asks  for  a  loan,  according  to  a 
Pennsylvania  banker,  with  the  remark  that  "I  may 
need  it." 

But  even  in  communities  where  interest  rates  are 
low  and  business  men  are  jealous  of  their  bank  balances 


48  BANK  CREDIT 

a  considerable  proportion  of  loans  may  be  productive 
of  no  large  ^-olume  of  derivative  deposits.  When  a 
large  proportion  of  a  bank's  advances  take  the  form  of 
paper  bought  from  paper  dealers — notes  of  distant 
borrowers — the  ratio  of  derivative  deposits  to  com- 
bined advances  made  to  depositors  and  non-depositors 
may  be  decidedly  low.  Essentially  the  same  result  is 
obtained  when  advances  are  made  on  mortgage  secu- 
rity. The  Indiana  bank  included  in  the  table  above 
reports  that  about  65  per  cent  of  its  loans  are  made  on 
commercial  paper  and  mortgages;  and  that  on  such 
loans  practically  no  deposits  are  left  with  the  bank. 
The  remaining  35  per  cent  of  loans  are  made  to  local 
commercial  borrowers,  who  are  also  depositors,  and 
about  25  per  cent  of  the  amount  loaned  to  these  de- 
positors remain,  on  an  average,  with  the  bank  for  the 
duration  of  the  loans.  With  the  six  banks  of  Freeport, 
Illinois,  there  is  no  large  local  demand  for  bon'owed 
money,  and  one  carries  over  a  half  milhon  dollars  in 
loans  secured  largely  by  mortgages  on  farms  in  states 
farther  north  and  west.  A  bank  at  Pecatonica,  lUi- 
nois,  with  bonds  and  receivables  totahng  ^410,000, 
loaned  locally  only  $81,000.  Banks  of  this  character 
have  a  small  volume  of  derivative  deposits;  the  ratio 
of  derivative  deposits  to  loans  is  low. 

Collateral  loans  represent  another  class  of  advances 
from  which  small  derivative  deposits  result.  Funds 
derived  from  time  or  demand  loans  secured  by  market- 
able collateral  tend  to  be  drawn  out  immediately,  as 
they  are  frequently  needed  for  a  specific  purpose.  At 
the  maturity  of  such  loans  the  collateral  is  usually 
sold  by  the  holder,  and  the  debt  to  the  bank  discharged; 


THE  PHILOSOPHY  OF  BANK  CREDIT  49 

or,  funds  may  become  available  from  some  other 
source  definitely  in  the  borrower's  mind  from  the  be- 
ginning of  the  loan,  and  the  collateral  may  be  freed  by 
the  appUcation  of  such  funds.  Whenever  a  banker 
makes  most  of  his  advances  on  collateral,  he  may  al- 
most certainly  count  upon  only  a  small  percentage 
being  left  on  deposit.  Collateral  loans  as  an  element  in 
the  banker's  advances  tend  to  depress  the  ratio  of 
derivative  deposits  to  loans. 

Whether  loans  are  secured  or  unsecured,  the  time 
element  will  have  its  influence  on  the  ratio  under 
examination.  Other  things  being  equal,  a  short  ma- 
turity favors  a  high  ratio,  and  a  long  or  deferred 
maturity  a  low  ratio.  The  shorter  the  loan  period  the 
larger  will  the  high  balances  of  the  early  and  closing 
days  of  a  loan  bulk  in  relation  to  the  loan  itself.  Re- 
newals are,  accordingly,  inimical  to  a  high  derivative 
balance  in  relation  to  loans  and  tend,  therefore,  to  be 
less  profitable  to  the  banker  than  advances  that  are 
not  renewed. 

The  size  of  the  loan,  or  rather  the  size  of  the  bor- 
rower, may  also  be  a  factor  bearing  upon  the  deriva- 
tive deposit-loan  ratio.  A  banker  on  the  Pacific  Coast 
points  out  that  ''among  those  who  borrow,  say  $5,000, 
or  less,  the  average  balance  would  run  close  to  forty 
per  cent  of  the  outstanding  loan,  over  the  larger  period 
of  the  advance.  As  loans  run  into  larger  figures,  the 
proportion  of  balance  seems  to  reduce  to  around  ten 
per  cent."  The  argument  of  the  large  borrowers  is  that 
''they  would  prefer  to  sell  their  paper  to  commer- 
cial paper  brokers  and  pay  the  additional  commission 
than  to  lose  the  earning  capacity  of  the  money  tied 


50  BANK  CREDIT 

up  in  compensating  balances  with  their  bank."  The 
small  business  man,  whose  scale  of  borrowing  opera- 
tions is  not  large  enough  to  arouse  the  interest  of  the 
commercial  paper  broker  is  apparently  subject  to  a 
restraining  influence  in  the  withdrawal  of  borrowed 
funds  that  does  not  stay  the  hand  of  the  big  borrower 
whose  access  to  the  loan  market  through  paper  brokers 
is  easy  and  economical. 

Still  one  more  determinant  of  the  ratio  under  con- 
sideration is  the  firmness  with  which  bankers  are  able 
to  fix  and  enforce  requirements  as  to  the  customer's 
balance  in  relation  to  accommodation  extended.  A 
bank  ha\'ing  strict  requirements  as  to  minimum  bal- 
ances in  relation  to  loans  would  tend  to  have  relatively 
high  derivative  deposits,  and  vice  versa.  Requirements 
as  to  balances  in  relation  to  loans  are  in  turn  governed 
to  an  appreciable  extent  by  such  forces — conflicting, 
it  may  be — as  banking  competition,  the  rate  of  interest 
charged  borrowers,  custom,  etc.  A  San  Francisco 
banker  agreeing  upon  a  credit  of  $100,000  would  ordi- 
narily stipulate  that  the  balances  should  run  15  per  cent 
of  the  amount  advanced,  whereas  a  New  York  institu- 
tion would  commonly  require  20  per  cent.  In  each 
case,  of  course,  the  balances  maintained  when  the 
account  w^as  not  borrowing  would  be  a  consideration 
in  determining  the  maximum  credit. 

Inasmuch  as  banks  become  comparatively  strict 
with  reference  to  balances  maintained  in  relation  to 
loans  during  periods  of  prosperity  and  expansion,  when 
borrowers  tend  to  strain  their  credit,  the  ratio  of  deriv- 
ative deposits  to  loans  may  then  rise  decidedly  higher 
than  during  less  prosperous  times.     The  heavy  and 


THE  PHILOSOPHY  OF  BANK  CREDIT  51 

insistent  demands  of  borrowers  for  funds  during  a 
period  of  expansion,  rising  prices,  and  swollen  profits, 
place  the  lending  banker  in  an  advantageous  position 
to  exact  the  maintenance  of  high  balances  in  relation 
to  loans.  ''You  are  straining  your  credit,"  says  the 
banker  to  the  credit-seeking  customer,  ''and,  with 
tight  money  staring  us  in  the  face,  I  shall  have  to  ask 
you  to  keep  a  more  liberal  balance  in  relation  to  loans 
than  previously,  as  a  requisite  to  additional  accommo- 
dation." A  relatively  high  ratio  of  derivative  deposits 
to  loans  is  a  part  of  the  price  that  the  borrower  may 
have  to  pay  for  the  use  of  funds  during  periods  of  ex- 
pansion. We  may,  therefore,  bring  forward  business 
conditions  and  the  state  of  trade, — the  business  cycle, 
— as  among  the  niunerous  factors  determining  the 
ratio  of  derivative  deposits  to  loans. 

In  short,  where  loans  are  made  mainly  to  merchants 
and  manufacturers  as  distinct  from  farmers  and  live- 
stock men,  where  the  rate  of  interest  charged  to  bor- 
rowers is  low,  where  borrowers  court  the  esteem  and 
goodwill  of  their  bankers  against  the  time  of  financial 
need,  where  loans  on  collateral  and  mortgage  security 
are  of  slender  proportions,  where  lines  of  credit  do  not 
run  into  large  figures,  where  maturities  are  short  and 
paper  seldom  renewed,  where  the  peddler  of  commer- 
cial paper  is  rarely  seen,  where  requirements  as  to 
balances  are  strict  and  well  enforced  even  in  dull 
times, — there  the  ratio  of  derivative  deposits  to  loans 
will  be  high,  if  not  indeed  at  a  maximum.  Reverse  the 
conditions  and  you  reverse  the  result.  Under  typical 
conditions  in  the  United  States,  the  ratio,  as  we  have 
seen,  does  not  exceed  20  per  cent. 


52  BANK  CREDIT 

Aggregate  Derivative  Deposits  Tend  to  Remain  Constant 
in  Amount 

After  a  bank  has  struck  its  pace,  so  to  speak,  and  its 
loans  have  begun  to  mature,  aggregate  derivative 
deposits  tend  to  remain  constant  in  amount.  This  is 
shown  in  diagram  2,  which  is  a  series  of  derivative 
deposits  curves  each  similar  to  that  contained  in  dia- 
gram 1.  Here,  as  in  diagram  1,  time  is  measured  along 
the  horizontal  axis  and  derivative  deposits  by  the 
perpendicular  distance  above  the  line  M  N.  Vertical 
axes  erected  at  any  two  points  between  a  and  b  would 
cut  the  derivative  deposits  curv^es  in  such  a  way  that 
the  sum  of  the  vertical  distances  of  the  points  of  inter- 
section above  the  M  N  line  would  be  approximately 
equal  in  the  two  cases.  Another  and  perhaps  clearer 
way  of  saying  the  same  thing  is  that  if  any  given  per- 
pendicular axis,  or  vertical  line,  is  moved  from  left  to 
right  or  right  to  left  between  a  and  b  along  the  time 
line  M  N,  the  vertical  line  wdll  cut,  at  whatever  point 
it  may  be,  about  the  same  number  of  derivative  de- 
posits curv^es — some  going  up,  others  going  down — and 
at  points  approximately  the  same  distance  above  the 
M  N  line.  The  perpendicular  erected  at  c,  a  point  of 
time,  touches  first  a  derivative  deposits  curve  at  a 
point  so  low  as  to  indicate  a  derivative  deposit  balance 
of  only  about  3  per  cent  of  the  relative  loan.  The  next 
two  points  of  intersection,  as  we  follow  the  perpen- 
dicular upward,  indicate  a  balance  of  approximately  5 
per  cent  of  the  corresponding  loan  in  each  case;  then 
one  of  8  per  cent,  one  of  10  per  cent  and  one  of  14  per 
cent;  then  20  per  cent,  25  per  cent,  30  per  cent,  and  80 


THE  PHILOSOPHY  OF  BANK  CREDIT 


53 


54  BANK  CREDIT 

per  cent;  the  average  derivative  deposit  balance  being 
20  per  cent.  "Wliatever  point  of  time  is  taken,  the 
derivative  deposits  are  substantially  the  same  in 
amount. 

If  the  diagram  were  drawn  with  derivative  deposit 
curves  asymmetrical  and  representing  loans  of  varying 
maturities,  irregularity  would  tend  to  offset  irregu- 
larity, and  substantially  the  same  result  as  stated 
above  would  be  obtained,  as  such  a  diagram,  if  drawn 
by  the  reader,  would  plainly  show. 

Quantitative  Determination  of  Individual  Bank  Loan  Ex- 
pansion Traceable  to  the  Acquisition  of 
Primary  Deposits 

Our  imderstanding  of  the  nature  of  commercial 
banking  operations  and  of  the  nature  of  primary  and 
derivative  deposits  will  enable  us  now  to  proceed  with 
the  development  of  a  formula  for  the  determina- 
tion of  the  amount  that  any  given  individual  bank 
in  a  system  can  add  to  its  item  of  loans  and  dis- 
counts on  the  basis  of  additional  reserve  deposited 
with  the  bank. 

The  magnitudes  involved,  with  convenient  abbrevia- 
tions, are  as  follows: 

The  additional  cash  or  reserve  (c) ; 
Overflow  cash,  i.  e.,  what  a  bank  tends  to  lose  as  the 
result  of  making  the  additional  loans  (ci); 

Loan  expansion  resulting  from  additional  cash  (x) ; 
The  ratio  of  cash  or  reserve  to  deposits  (r) ; 
The  ratio  of  derivative  deposits  to  loans  (k). 


THE   PHILOSOPHY   OF   BANK   CREDIT  55 

Since  (1  — k)  is  equal  to  the  percentage  of  loans 
checked  against  by  borrowers,  it  follows  that 

ci  =  (l-k)x. 

Since  the  lending  banker  will  make  his  loans  of  such 
an  amount  that  the  cash  left  in  the  bank  after  the  over- 
flow cash  has  been  paid  out  will  be  equal  to  the  reserve 
required  for  (1)  the  original  cash  deposit  and  (2)  the 
derivative  deposits  arising  from  the  loans,  (rc+rkx) 
would  equal  the  cash  which  the  banker  would  have  to 
retain  as  reserve,  c  being  the  amount  of  the  cash  de- 
posit and  kx  being  the  amount  of  the  derivative  de- 
posits, and  r  being  the  reserve-deposits  ratio.  If  (rc-f- 
rkx)  is  retained  by  the  bank,  the  amount  of  overflow 
cash,  Ci,  may  be  found  by  subtracting  (rc-hkrx)  from 
c.    Hence, 

Ci  =c— (rc-f-krx)  or  c— re— krx. 

Since  Ci  is  also  equal  to  (1  — k)x, 

(1— k)x=c— re— krx. 


Transposing, 


krx-F  (1 — k)x  =  c — re. 
or  (kr-f-1— k)x=c— re, 
c— re 


and  x  = 


or    x  = 


kr-hl-k 
c(l-r) 


kr+l-k 


The  application  of  the  formula  to  any  given  bank  is 
simple.  Take  a  deposited  cash  accretion  of  $1,000  in 
the  case  of  a  bank  having  a  reserve-deposits  ratio  of 


56  BANK  CREDIT 

10  per  cent  and  a  derivative  deposit-loan  ratio  of  20 
per  cent. 

Under  these  conditions 

c  =$1,000  r  =  .10  and   k  =  .20. 

Making  substitutions  in  the  formula,  in  order  to  ascer- 
tain the  loan  expansion  practicable  on  the  basis  of  the 
new  deposited   cash  amounting  to  $1,000,   we  have 

1000(1-. 10)     900       cino7CA 
x=    ^^    • — -~-=-^^or  $1097.56 
.02+1 -.20      .82 

The  application  of  the  formula  indicates  of  course 
that  the  amount  ascertained  can  be  loaned  in  excess 
of  what  could  have  been  loaned  had  the  additional  pri- 
mary deposits  not  been  obtained.  If,  owing  to  gold 
exports  or  other  circumstances,  banks  were  contracting 
their  loans,  the  acquisition  of  additional  primary  de- 
posits by  a  given  bank  might  serve  only  to  prevent  or 
even  check  contraction  of  its  loans  by  the  amount 
ascertained  bj^  the  appUcation  of  the  formula. 

It  is  evident  from  a  glance  at  the  formula  that  the 
higher  the  cash-deposits  ratio,  the  lower  will  be  the 
loan  expansion:  and  the  higher  the  derivative  deposit- 
loan  ratio,  the  greater  the  loan  expansion. 

It  is  also  observable  that  whenever  (1— r)  is  equal 
to  kr+1— k,  the  loan  expansion  rendered  practicable 
by  an  additional  primary  deposit  will  equal  that  pri- 
mary deposit.  The  following  table  gives  combinations 
of  cash-deposit  and  derivative  deposit-loan  ratios  that 
admit  of  loan  expansion  equal  to  additional  primary 
deposits. 


THE  PHILOSOPHY  OF  BANK  CREDIT 


57 


'^ash-Deposit 

Derivative  Deposit-Loan 

Ratio 

Ratio 

5  per  cent 

and 

5.26  per  cent 

7    "    " 

and 

7.52     "    '' 

10    "    " 

and 

11.11    "    " 

13    "    '' 

and 

14.94    "    " 

15    "    " 

and 

17.64    "    " 

17    "    " 

and 

20.48    "     " 

20    "     " 

and 

25.00    "    " 

Since  kr  is  of  very  slight  quantitative  importance, 
being  only  a  fraction  of  a  fraction,  it  follows  that  if 
(1— r)  in  the  numerator  of  the  formula  is  matched 
quantitatively  by  1— k  in  the  denominator,  i.  e.,  if  r 
equals  k,  the  bank  to  which  the  magnitudes  relate 
would  be  able  to  keep  its  loans  moving  upward  in 
almost  equal  step  with  increasing  primary  deposits. 

Qualifications  of  the  Formula 

c(l— r) 

The  formula,  x  = , — ^^ — ,  calls  for  qualification.    A 

kr4- 1  —  k 

certain  proportion  of  checks  drawn  by  borrowers  will 
be  in  favor  of  depositors  of  the  drawers'  bank  and,  to 
that  extent,  cause  no  loss  of  cash  hy  that  bank.  Over- 
flow cash,  it  may  be  contended,  particularly  in  a  coun- 
try having  few  banks,  and  especially  in  one-bank 
towns,  would  be  reduced,  and  the  bank's  lending 
power  made  greater  than  would  be  indicated  by  the 
formula. 

The  importance  of  this  contention  is  minimized, 
however,  if  we  bear  in  mind  that  the  ties  and  relations 
of  trade  and  exchange  between  community  and  com- 


58  BANK  CREDIT 

munity,  section  and  section,  are  so  numerous  and  of 
such  far  reaching  ramifications  as  to  make  certain  the 
very  early  drawing  of  checks  by  customers  of  the  bank 
that  receives  an  addition  to  its  primary  deposits  in 
favor  of  creditors  that  are  not  depositors  in  the  drawers' 
bank. 

But  we  will  not  deny  that  the  drawing  of  checks  by 
borrowers  in  favor  of  depositors  of  the  lending  bank 
has  almost  the  same  significance  to  the  lending  bank 
as  a  higher  ratio  of  derivative  deposits  to  loans:  instead 
of  leaving  borrowed  funds  on  deposit  in  his  own  name, 
the  borrower  transfers  them  to  some  other  depositor 
of  the  same  bank. 

To  this  qualification  may  be  added  a  second;.  Any 
given  bank,  bank  A,  let  us  say,  which  has  extended  its 
loans  on  the  basis  of  new  reserve  may  become  the 
depository  for  overflow  cash  lost  by  other  banks  in  the 
system  that  have  themselves  loaned  on  the  basis  of 
cash  received  as  a  result  of  the  loans  made  by  bank  A. 
Such  a  back-flow  of  overflow  cash  would  be  tantamount 
to  a  correspondingly  higher  ratio  of  derivative  deposits 
to  loans.  In  a  country  like  Canada  or  Scotland, 
having  only  a  few  banks,  this  consideration  has  great 
significance;  in  the  United  States,  with  more  than 
twenty  thousand  commercial  banks,  it  is  of  little 
quantitative  importance. 

A  third  circumstance  needs  to  be  mentioned  in  this 
connection.  Discount  taken  by  a  bank  at  the  incep- 
tion of  an  advance,  making  the  proceeds  thereof  some- 
what less  than  the  face  of  the  borrower's  obligation, 
would  add  very  slightly  to  the  loan  expansion  as  ascer- 
tained by  the  formula.    The  proceeds  of  the  advance 


THE  PHILOSOPHY  OF  BANK  CREDIT  59 

being  less  than  the  advance  itseK,  overflow  cash  would 
be  correspondingly  reduced,  and  the  loan  expansion 
at  the  time  somewhat  greater  than  if  the  bank  deducted 
no  compensation. 

Perhaps  we  shall  give  due  weight  to  the  qualifying 
factors  just  mentioned,  if  we  think  of  the  derivative 
deposit-loan  ratio  of  a  representative  American  bank 
as  approximating  the  maximum  estimate  of  20  per 
cent  given  on  page  45  rather  than  either  the  simple 
arithmetical  average  or  median,  10  per  cent. 

It  is  desirable  in  passing  that  attention  be  called 
to  the  use  of  the  phrase  '4oan-expansion"  (or  ''addi- 
tion to  loans").  On  account  of  a  lag  between  the  time 
a  loan  is  made  and  the  payment  of  checks  drawn 
against  the  proceeds,  there  tends  to  be  an  interval 
during  which  larger  loans  might  be  made  than  the 
application  of  the  formula  would  indicate.  It  is 
equally  important,  however,  to  observe  that  the  mid- 
dle period  of  an  advance  witnesses  a  marked  depression 
in  the  derivative  deposits  curve  (see  diagram  1)  which 
offsets  the  high  derivative  balances  at  the  first  and 
last  ends  of  the  loan  period.  The  phrase  "loan  expan- 
sion" encompasses  the  entire  life-span  of  the  advances 
made. 

The  Distribution  of  New  Reserve  as  the  Foundation  of 
Manifold  New  Loans 

So  far  we  have  been  concerned  with  how  great  an 
addition  an  individual  bank  could  make  to  its  loans 
and  discounts  as  a  result  of  the  net  addition  of  a  given 
amount  of  primary  deposits.  Let  us  turn  now  to  the 
less  difficult  matter  of  the  way  in  which  7iew  cash  be- 


GO  BANK  CREDIT 

comes  widely  distributed  as  the  basis  of  new  and 
manifold  loans  in  the  banking  system. 

It  has  been  seen  that  the  deposit  of  a  given  sum  of 
new  resen^e  tj'pically  admits  of  the  extension  of  loans 
somewhat  in  excess  of  that  sum  by  the  bank  receiving 
the  deposit,  and  that  the  loan  expansion  in  tmn  re- 
sults in  an  overflow  of  cash,  somewhat  less  than  that 
deposited,  to  other  banks  in  the  system.  The  over- 
flow cash  in  the  banks  to  which  it  goes  also  becomes 
the  foundation  of  loans  somewhat  greater  than  itself; 
and  these  loans  in  turn  are  productive  of  an  overflow 
of  cash  somewhat  less  than  the  previous  overflow. 
This  chain  of  operations  continues,  each  bank  that 
receives  a  part  of  the  overflow  at  any  stage  of  the  proc- 
ess retaining  a  fraction,  but  only  a  fraction,  of  what 
it  receives,  until  the  cash  becomes  very  widely  distrib- 
uted, and  the  total  loan  expansion  results  m  deposits 
sufficient  to  take  up  the  slack  in  the  reserv^e-deposits 
ratio  of  the  banking  system.  If  the  reser\^e-deposits 
ratio  is  1  to  10,  the  total  loan  expansion  would  be  9 
times  the  amount  of  new  cash,  as  already  explained. 

The  nature  and  significance  of  the  series  of  opera- 
tions just  described  may  be  showTi  by  means  of  dia- 
gram 3.  The  first  rectangular  area  at  the  left,  marked 
c,  represents  a  given  amount  of  cash  or  reserve  lodged 
in  bank  A.  The  area  p  directly  below  the  cash  area, 
and  equal  to  it,  represents  the  deposit  arising  from  the 
receipt  of  the  reserve  by  the  bank.  It  has  been  shown 
that  an  indi\adual  bank  having  a  cash-deposits  ratio 
of  10  per  cent  and  a  derivative  deposit-loan  ratio  of 
20  per  cent  may  make  new  loans,  in  addition  to  its 
normal  volume  of  loans,  somewhat  in  excess  of  a  given 


i 


c 

Ol 


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tc^ 


I 


5 
0 

'*^     t 

J)    c 

^  1 «  <«  ^_ 
0    X    vT 


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Q 


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61 


62  BANK  CREDIT 

addition  to  its  cash.  Accordingly,  rectangle  x,  repre- 
senting loans  made  as  a  result  of  the  lodgment  of  the 
reserve,  is  somewhat  larger  than  rectangle  c.  As  a 
consequence  of  making  loans  represented  by  rectangle 
X,  the  bank  loses  cash,  "overflow"  cash,  indicated  by 
rectangle  Ci,  which  is  equal  to  the  unshaded  portion 
of  area  c.  Rectangle  x,  new  loans,  minus  rectangle 
ci,  "overflow"  cash,  must  give  rectangle  d,  derivative 
deposits.  Rectangle  c  minus  rectangle  Ci  gives  residual 
reserve,  i.  e.,  that  portion  of  the  new  reser\^e  lodged  in 
bank  A  which  is  retained  by  bank  A.  Retained  or 
residual  reserv'e  is  represented  in  rectangle  c  (and  in 
all  the  "overflow"  cash  rectangles)  by  a  small  darkened 
area.  Rectangle  pi  indicates  deposits  traceable  to  the 
receipt  of  "overflow"  cash  by  bank,  or  group  of  banks, 
B.  Rectangle  xi  represents  loans  made  by  bank,  or 
group  of  banks,  B,  on  the  basis  of  the  "overflow"  cash 
received  from  bank  A.  Rectangle  C2  represents  "over- 
flow" cash  received  from  bank,  or  group  of  banks,  B, 
by  bank  or  group  of  banks  C;  rectangle  X2,  the  conse- 
quent new  loans  made;  rectangle  P2,  deposits  arising 
from  the  receipt  of  "overflow"  cash  and  d2,  derivative 
deposits.  The  same  circle  of  explanation  continues 
with  reference  to  the  magnitudes  remaining  imtil 
"overflow"  cash  finally  becomes  a  negligible  quan- 
tity. 

The  sum  of  the  series  x,  xi,  X2,  .  .  .  etc.  is  equal  to  X, 
the  loan  expansion  traceable  to  c  within  the  banking 

system,  X  being  equal  to ^ The  sum  of  the  two 

XV 

series  p,  pi,  p2,  .  .  .  etc.  and  d,  di,  d2,  .  .  .  etc.  is  equal 
to  D,  the  expansion  of  deposits  within  the  system,  which 


THE  PHILOSOPHY  OF  BANK  CREDIT  63 

in  turn  equals  ^-    (In  this  chapter  r  is  used  to  indicate 
it 

the  reserve-deposits  ratio  of  the  individual  banks,  and  R, 

the  reserve-deposits  ratio  in  the  system  as  a  whole. 

Since  the  system  of  banks  is  assumed,  for  the  sake  of 

simplicity,  to  be  homogeneous,  r  =  R.) 

Relation  of  Loans  to  Deposits 

An  examination  of  the  diagram  will  show  clearly  the 
relation  of  deposits  to  loans  and  of  loans  to  deposits 
in  an  individual  bank  and  in  the  system  as  a  whole. 
It  is  evident  that  loans  when  made  by  a  bank  or  group 
of  banks  rest  chiefly  upon  primary  deposits.  An 
addition  made  to  the  loan  item  on  the  basis  of  a  pri- 
mary deposit  may  somewhat  exceed  that  deposit  in 
amount ;  but  at  the  time  the  loan  is  made  there  is  a  foun- 
dation of  reserve  resulting  from  the  primary  "deposit" 
only  slightly  less  than  the  new  loan.  The  possession  of 
reserve  to  an  amount  nearly  equal  to  new  loans  is  a 
prerequisite  to  making  such  loans.  In  order  that  a 
bank  may  add  a  given  amount,  $100,000  or  $1,000,000, 
to  its  loan  item  it  is  essential  that  the  bank  secure  new 
primary  deposits  approximately  as  great.  Hence  the 
struggle  for  primary  deposits.  In  the  case  of  an 
individual  bank,  additional  reserve  arising  from  pri- 
mary ''deposits"  (not  to  mention  cash  arising  from  the 
payment  of  capital  stock  or  surplus)  conditions  funda- 
mentally the  amount  of  additional  loans. 

Moreover,  the  loans  of  one  bank  give  rise  to  deposits 
— somewhat  less  than  those  loans — of  other  banks,  the 
process  continuing  with  the  primary  deposits  approach- 
ing zero  as  a  limit,  as  shown  in  the  diagram.    The  loans 


64  BANK  CREDIT 

of  any  given  bank,  (bank  A  in  the  diagram,  for  exam- 
ple,) also  result  in  derivative  deposits  for  that  bank  of 
such  magnitude  that,  if  added  to  the  primary  deposits 
made  in  bank  or  group  of  banks  B,  as  a  result  of  the 
loans  made  by  bank  A,  will  equal  the  loans  made  by 
bank  A.  It  follows  that  for  the  hanking  system  deposits 
are  chiefly  the  offspring  of  loans.  For  an  individual 
bank  loans  are  the  offspring  of  deposits. 

How  the  Withdrawal  of  Cash  from  an  Individual  Bank 

Effects  a  Wide-Spread  Contraction  of  Loans  and 

Deposits 

The  explanation  given  of  the  way  in  which  an  in- 
crease in  the  cash  holdings  of  a  bank  results  in  a  general 
expansion  of  loans  also  enables  us  to  understand  the 
way  in  which  the  withdrawal  of  cash  from  a  bank 
tends  to  effect  a  general  contraction  of  loans.  A  depos- 
itor's withdrawal,  for  export,  of  cash  of  $1,000,000,  let 
us  say,  from  bank  A  in  the  diagram  would  normally 
require  bank  A  to  contract  its  loans,  not  hy  $1,000,000 
but  hy  SI, 097, 560. 97;  otherw^ise  its  cash-deposits  ratio 
would  be  distorted.  Since  the  loans  gave  rise,  during 
the  loan  period,  to  a  derivative  deposit  of  20  per  cent, 
the  loan  contraction  of  bank  A,  amounting  to  Sl,097-, 
560.07,  would  draw  in  cash  of  only  $878,048.78  from 
the  other  banks  in  the  system, — in  a  fashion  just  the 
reverse  of  the  way  in  which  that  cash  became  distrib- 
uted; and  bank  A,  after  losing  the  SI, 000,000  in  cash 
would  be  in  the  same  situation  as  before  its  receipt  as  a 
deposit  and  the  consequent  loan  expansion.  The  dif- 
ference between  81,000,000  that  the  bank  would  lose 
and  S878,048.78  that  would  be  drawn  in  through  loan 


fHE  PHILOSOPHY  OF  BANK  CREDIT  65 

contraction  would  be  made  up  of  cash  held  as  a  10  per 
cent  reserve  against  (a)  the  primary  deposit  of  $1,000-, 
000,  now  being  withdrawn,  and  (b)  the  derivative  de- 
posit of  $219,512.19. 

If  the  deposit  account  of  Barker,  Brown  and  Com- 
pany is  transferred  from  the  Chase  National  Bank  of 
New  York  to  the  Chemical  National  Bank,  the  former 
will  tend  to  contract  its  loans  by  an  amount  somewhat 
in  excess  of  the  deposit  balance  transferred,  in  order  to 
meet  the  unfavorable  clearing  house  balance  arising 
from  the  loss  of  the  account.  The  calling  of  the  loan 
by  the  Chase  sets  in  motion  a  circle  of  loan  contraction, 
entailing  a  loss  of  cash  by  bank  to  bank, — the  loss 
diminishing  as  the  circle  spreads.  But  the  spread  of 
the  circle  of  contraction,  with  its  concentric  movement 
of  cash  will  very  soon  be  opposed  by  the  spread  of  a 
circle  of  expansion  incident  to  loan  extension  by  the 
Chemical,  based  on  the  cash  received  from  the  Chase 
as  a  result  of  the  transfer  of  the  account  of  Barker, 
Brown  and  Company.  In  the  circle  of  contraction 
set  in  motion  by  the  Chase  the  force  of  the  movement 
of  cash  is  centripetal.  In  the  circle  of  expansion  set  in 
motion  by  the  expanded  loans  of  the  Chemical  the 
force  affecting  the  cash  is  centrifugal.  The  strength  of 
the  force  in  each  case,  speaking  loosely,  if  not  jocosely, 
would  vary  inversely  with  the  distance.  Let  the 
reader  observe  again  the  darkened  areas  in  the  dia- 
gram. 

It  is  important  not  to  overlook  the  fact  that  the 
loan  expansion  of  the  Chemical  National  Bank  as  a  re- 
sult of  acquiring  a  new  deposit  account  was  roughly 
equal  to  the  loan  contraction  which  the  loss  of  the 


66  BANK  CREDIT 

account  necessitated  in  the  case  of  the  Chase.  Just  as 
it  was  necessary  for  the  Chase  to  contract  its  loans 
only  slightly  in  excess  of  the  amount  of  the  balance 
transferred  in  order  to  meet  the  unfavorable  balance 
arising  from  the  transfer,  so  the  loan  expansion  of  the 
Chemical  that  was  rendered  practicable  by  the  ac- 
quisition of  the  cash  coming  through  the  clearing 
house  as  a  result  of  the  transfer  of  the  account  would 
be  only  sUghtly  in  excess  of  the  new  cash  received. 

Banks  struggle  to  secure  the  accounts  of  their  com- 
petitors' customers,  not  because  the  new  cash  arising 
from  the  new  deposit  balances  will  enable  them  to 
lend  several  times  the  amount  of  the  deposits,  but 
because  it  will  enable  them  to  lend  approximatel}''  as 
much  as  the  deposits, — and  on  the  average  probably  a 
little  more. 

Why  Banks  Compete  for  Deposits 

Now  the  customary  and  current  explanation  of  the 
theory  of  bank  credit  maintains  that  a  bank  can  lend 
eight  or  ten  times  the  amount  of  its  cash  deposits. 
"That  explains,"  says  Professor  Agger, ^  "why  the 
bank  can  afford  to  maintain  an  expensive  establish- 
ment, to  supply  stationery  and  to  undertake  free  of 
charge  the  collection  of  checks,  coupons,  etc.,  for  its 
depositors.  In  the  banking  business  nothing  succeeds 
like  deposits." 

Apart  from  the  demonstration  already  given  that 
an  addition  to  the  deposits  of  a  bank  normally  carries 
a  power  of  loan  extension  only  approximately  equal 

1  Eugene  E.  Agger,  Organized  Banking,  Henry  Holt  and  Com- 
pany, New  York,  1918,  p.  33. 


THE  PHILOSOPHY  OF  BANK  CREDIT  67 

to  the  cash  acquired,  it  should  be  pointed  out  that 
bankers  would  scarcely  feel  constrained  to  make  so  low 
a  bid  for  deposits  as  they  now  make,  if  their  lending 
power  were  enhanced  by  eight  or  ten  times  the  amount 
of  the  deposit.  If  a  banker  were  able  to  lend  $50,000  as 
the  result  of  securing  a  new  primary  deposit  of  $5,000, 
why  would  he  hesitate  to  pay  interest  on  the  deposit? 
Would  not  competition  force  the  rate  paid  on  deposits 
above  the  nominal  figures  now  obtaining? 

A  representative  bank  with  a  cash-deposits  ratio 
of  10  per  cent  and  a  derivative  deposit-loan  ratio  of 
20  per  cent,  securing  additional  primary  deposits  of 
55200,000  would  be  able  to  add  approximately  $220,000 
to  its  loan  item  and  would  retain  approximately  $24-, 
400  in  cash  as  a  reserve  against  the  $244,000  deposits 
($200,000  primary  deposits  and  $44,000  derivative) 
owed  by  the  bank  after  the  proceeds  of  the  loans  had 
been  drawTi  against  by  the  borrowers.  Its  loans  would 
be  approximately  nine  times  the  cash  on  hand  but 
the  cash  on  hand  would  be  only  a  fraction  of  the  cash 
deposited.  Primary  deposits  have  almost  no  multi- 
plicative importance  as  a  basis  for  loans.  A  represen- 
tative bank  is  able  to  pay  reasonably  large  dividends, 
not  because  primary  deposits  can  be  made  the  basis  of 
manifold  loans  by  that  bank,  but  because  its  total 
loans  (and  mvestments)  are  several  times  the  amount 
of  the  bank's  capital. 

A  representative  commercial  bank  in  the  United 
States  has  loans  and  discounts  equal  roughly  to  ten 
times  its  capital.  Its  gross  earnings  from  interest  and 
discount  therefore  would  be  sufficient  to  pay  a  divi- 
dend of  50  per  cent  upon  the  capital,  if  the  bank 


68  BANK  CREDIT 

charged  its  borrowing  customers  5  per  cent  on  their 
loans.  The  expenses  of  the  business  might  absorb  one- 
half  or  three-quarters  of  the  gross  earnings  and  still 
leave  an  amount  ample  for  dividend  purposes.  Bank- 
ing is  profitable,  not  because  an  individual  bank  can 
lend  ten  dollars  as  a  result  of  receiving  one  dollar  on 
deposit,  which  is  not  true,  but  essentially,  because  a 
bank  can  normally  lend  an  amount  roughly  equal  to 
its  primary  deposits.  As  primary  deposits  are  a  req- 
uisite to  and  (roughly  speaking)  a  measure  of  loans, 
these  deposits  are  eagerly  sought  as  an  indirect  source 
of  profit.  How  much  more  eagerly  they  W'Ould  be 
sought  if  they  conferred  upon  the  bank  receiving  them 
the  power  to  lend  ten  times  their  amount,  as  the  cur- 
rent theory  holds,  is  problematical. 

The  Assimilation  of  an  Individual  Bank  to  the  System 

The  way  in  which  an  individual  bank  during  the 
early  stages  of  its  existence  becomes  assimilated  to 
the  system  is  now  easily  explained.  Let  us  suppose 
that  a  newly  established  bank  haidng  a  capital  of 
$100,000,  paid  in  cash,  receives  cash  deposits  of  $200-, 
000  and,  further,  that  the  bank  invests  $75,000  in 
government  bonds,  and  $25,000  in  building,  furniture 
and  fixtures.    The  balance  sheet  would  show : 

Assets  Liabilities 

U.  S.  Bonds S  75,000    Capital $100,000 

Real  Estate,  Furniture 

and  Fixtures 25,000    Deposits 200,000 

Cash 200,000 

$300,000  $300,000 


THE  PHILOSOPHY  OF  BANK  CREDIT  69 

How  much  can  this  bank  lend  without  impairing  its 
cash-deposits  ratio,  and  without  obtaining  additional 
primary  deposits,  if  a  cash-deposits  ratio  of  1  to  10  is 
determined  upon  as  affording  a  maximum  profit  con- 
sistent with  reasonable  security  against  a  shortage  of 
cash  and  if,  also,  the  bank  enjoys  a  20  per  cent  ratio 
of  derivative  deposits  to  loans?  Since  the  bank  in 
question  has  a  derivative  deposit-loan  ratio  of  1  to  5 
or  20  per  cent  and  a  cash-deposits  ratio  of  10  per  cent, 
it  would  be  able  to  lend,  the  apphcation  of  the  formula 
shows,  approximately  $220,000.00  and  would  lose 
approximately  $175,000.00  in  reserve  to  other  banks 
in  the  system.  Any  additional  loans  would  be  condi- 
tioned by  additional  'primary  deposits,  or  to  speak 
more  accurately,  by  additional  reserve  acquired,  the 
acquisition  of  which  would  give  rise  to  primary  de- 
posits. 

The  application  of  our  formula  will  show  that  the 
balance  sheet  of  the  banlc  under  consideration,  after 
unfavorable  clearing  house  balances  arising  from  the 
withdrawal  of  loan-proceeds  have  been  paid,  would 
present  the  following  items. 

Assets  Liabilities 

Loans  and  Discounts. .  $219,512 .  19    Capital $100,000 .  00 

U.  S.  Bonds 75,000 .  00    Deposits 243,902 .  44 

Real    Estate,    Furni- 
ture and  Fixtures .  .     25,000 .  00 
Cash 24,390.25 


$343,902.44  $343,902.44 

If,  as  time  passes,  the  bank  secures  additional  pri- 
mary deposits  of  $400,000  it  would  be  able  to  increase 


70  BANK  CREDIT 

its  loans  to  $658,536.57.  Its  volume  of  deposits  would 
then  be  raised  to  $731,707.30  and  its  cash  to  $73,170.73, 
and  the  statement  would  stand  as  follows: 

Assets  Liabilities 

Loans  and  Discounts. .  $658,536 .  57    Capital $100,000 .  00 

U.  S.  Bonds 75,000.00    Deposits 731,707.30 

Real    Estate,    Furni- 
ture and  Fixtures . . .     25,000 .  00 
Cash 73,170.73 


$831,707.30  $831,707.30 

For  the  sake  of  greater  clarity  in  the  development 
of  all  the  formulas  thus  far  given,  slight  cognizance  has 
been  taken  of  bank  profits  consisting  of  interest  or 
discount.  Although  the  inclusion  of  such  profit  was 
not  necessary  to  estabUsh  the  general  principles  devel- 
oped, it  will  not  be  amiss  now  to  say  that  undivided 
profits  are  invested  without  at  any  time  being  set  aside 
as  ear-marked  funds.  If  invested  in  loans  and  dis- 
counts, such  profits  remain  in  the  bank  only  to  the 
same  extent  as  does  cash  which  when  lodged  in  the 
bank,  matching  primary  deposits,  justifies  an  increase 
in  loans.  There  is  one  point  of  difference;  no  reserve 
needs  to  be  maintained  against  undivided  profits. 
Accordingly,  cash  that  represents  the  payment  of 
interest  or  discount  or  other  form  of  undivided  profits, 
constitutes  a  base  for  somewhat  greater  loan  expansion 
by  an  individual  bank  than  does  the  same  amount  of 
cash  arising  from  deposits.  Thus  $10,000  net  profit 
arising  from  banking  operations  and  temporarily  held 
by  the  bank  in  cash  as  surplus  reserve  would  justify  an 


THE  PHILOSOPHY  OF  BANK  CREDIT  71 

extension  of  loans  amounting  to  $12,195.12,  if  a  cash- 
deposits  ratio  of  10  per  cent  is  adhered  to  and  20  per 
cent  of  the  funds  borrowed  are  left  on  deposit  on  the 
average.  1  As  80  per  cent  of  $12,195.12  or  $9,756.10 
would  be  checked  against  on  the  average,  a  reserve 
would  need  to  be  held  against  derivative  deposits  of 
$12,195.12— $9,756.10  or  $2,439.02;  that  is,  $243.90 
would  be  retained  by  the  bank  and  $10,000— $243.90 
or  $9,756.10  would  overflow  to  other  banks.  If  we 
now  incorporate  in  the  balance  sheet  the  item  of 
$10,000  undivided  profits,  loans  of  $12,195.12,  cash  in- 
crease of  $243.90,  deposits  increase  of  $2,439.02,  the 

1  The  formula  for  the  determination  of  the  amount  that  a  bank 

can  lend  on  the  basis  of  surplus  reserve  is,  x  =  u„  ,  i  _u,  where 

X  equals  the  loan  expansion;  c  the  surplus  reserve;  k,  the  ratio  of 
the  derivative  deposits  to  loans;  and  r,  the  cash-deposits  ratio. 

The  derivation  is  simple.  Since  k  equals  the  ratio  of  derivative 
deposits  to  loans,  the  lending  banker  knows  that  (1— k)  times  the 
amount  of  the  new  loan  will  be  withdrawn.  Therefore,  if  we  let  ci 
stand  for  overflow  cash,  ci  =  (l— k)x.  The  lending  banker  will 
make  his  new  loans  of  such  an  amount  that  after  the  overflow  cash 
has  been  let  go,  he  will  still  retain  a  suflBcient  amount  of  the  surplus 
reserve  to  constitute  a  reserve  against  the  derivative  deposit  result- 
ing from  the  loan ;  that  is,  the  banker  will  make  his  loans  of  such  an 
amount  that  ci  will  equal  c— kra;.  Since  ci  equals  (1— k)a;  and  also 
equals  c  —  krx, 

(1— k)a;  =  c— krx. 
Transposing,  krx-f-  (1— k)x  =  c. 
Or,  (kr-M-k)x  =  c, 

and, 


kr-t-l-k 


If  we  substitute  $10,000  for  c,  20  per  cent  for  k  and  10  per  cent 
for  r,  the  loan  expansion  of  $12,195.12  is  obtained. 


72  BANK  CREDIT 

statement  will  reflect  the  condition  of  a  bank  assimi- 
lated to  the  system: 

Assets  Liabilities 

Loans  and  Discounts .  .$670,731 .  69    Capital $100,000 .  00 

U.  S.  Bonds 75,000.00  Undivided  Profits     10,000.00 

Real    Estate,    Furni-  Deposits 734,146.32 

ture  and  Fixtures .. .     25,000.00 

Cash 73,414.63  

$844,146.32  $844,146,32 

The  reader  can  easily  calculate  the  loan  expansion 
that  would  be  practicable  in  the  case  just  considered, 
were  the  current  and  traditional  theory  a  piece  with 
the  facts. 

Summary — The  Old  Theory  and  the  New  Contrasted 

It  has  been  seen  that  the  current  theory  of  bank 
credit  is  predicated  upon  the  contention  that  a  bank 
would  be  able  to  make  loans  to  the  extent  of  several 
times  the  amount  of  additional  cash  newly  acquired 
and  held  at  the  time  the  loans  were  made,  whereas  a 
representative  bank  in  a  system  is  actually  able 
ordinarily  to  lend  an  amount  only  roughly  equal  to 
such  cash.  Writers  in  the  past  have  assumed  that  the 
ratio  of  loans  to  cash  on  hand  after  the  loans  were  made, 
as  in  the  case  of  a  representative  bank  thoroughly  as- 
similated to  the  system,  was  an  accurate  measure  of 
new  loans  that  could  be  extended  on  the  basis  of  new 
reserve.  They  have  overlooked  the  pivotal  fact  that 
an  addition  to  the  usual  volume  of  a  bank's  loans 
tends  to  result  in  a  loss  of  reserve  for  that  bank  only 
somewhat  less  on  the  average  than  the  amount  of  the 
additional  loans.    The  reserve  retained,  what  we  have 


THE   PHILOSOPHY   OF  BANK  CREDIT  73 

called  residual  cash  or  residual  reserve,  is  only  a  frac- 
tion, on  the  average  throughout  the  loan  period,  of 
additional  loans  made.  The  residual  cash  supports 
loans, — and  deposits, — several  times  as  great  as  itself, 
but  the  residual  cash  is  only  a  fraction  of  the  cash  ac- 
cretion, the  possession  of  which  prompts  the  banker  to 
expand  his  loans.  Manifold  loans  are  not  extended  by 
an  individual  bank  on  the  basis  of  a  given  amount  of 
reserve.  Instead,  as  a  consequence  of  lending,  the  re- 
serve of  the  individual  bank  overflows,  leaving  only 
the  equivalent  of  a  fractional  part  of  the  additional 
volume  of  loans  extended,  the  overflow  cash  finding  its 
way  to  other  and  still  other  banks  until  it  becomes  the 
"residualized,"  yet  shifting,  foundation  of  manifold 
loans  and  deposits. 

The  normal  ratio  of  cash  to  deposits  and  to  loans  in 
an  individual  bank,  in  a  word,  is  reached  through  the 
three-fold  process  of  (1)  cash  acquisition  coupled  with 
an  equal  addition  to  deposits  (2)  loan  expansion  with 
the  corresponding  deposits  heavily  drawn  against  by 
check,  resulting  in  (3)  cash  overflow  or  contraction. 
The  same  ratio  in  the  banking  system,  which  may  be 
likened  to  a  single  great  bank  doing  the  entire  banking 
business  of  the  country,  is  reached  through  the  two- 
fold process  of  (1)  cash  acquisition  offset  by  equal 
deposit  expansion  and  (2)  manifold  loan  and  deposit 
expansion.^     The  distinction  already  made  between 

1  As  will  be  shown  in  the  next  chapter  bank  loan  expansion  in  any- 
given  country  tends  to  result  in  an  "overflow"  of  cash  to  other 
countries,  analogously  to  the  individual  bank,  unless  an  offsetting 
credit  expansion  or  other  offsetting  circumstances  obtain  in  those 
other  countries. 


74  BANK  CREDIT 

the  maimer  of  the  loan  expansion  of  an  individual  bank 
and  that  of  the  banking  system  is  at  once  the  founda- 
tion and  pinnacle  of  the  theory  here  advanced. 

Anticipated  Criticism  Answered 

It  is  anticipated  that  criticism  of  the  theory  devel- 
oped in  this  chapter  will  center  around  the  contention 
that  an  individual  bank  can  lend  as  a  result  of  a  de- 
posited accretion  to  its  reserves,  and  without  an  im- 
pairment of  its  reserv^es,  an  amount  roughly  equal  to 
the  product  of  the  reserve  accretion  and  the  deposits- 
reserve  ratio  (not  reserve-deposits  ratio)  of  the  bank, 
the  contention  being  based  on  the  notion  that  the  new 
loans  would  result  in  no  loss  of  cash  by  the  lending 
bank  because  checks  drawn  upon  the  lending  bank  by 
its  depositor-borrowers  against  the  deposited  pro- 
ceeds of  the  new  loans  would  be  offset  by  the  deposit  in 
the  lending  bank  of  a  corresponding  amount  of  checks 
— received  by  its  customers  in  the  course  of  business 
— drawn  upon  other  banks  in  consequence  of  loans  made 
by  those  other  banks  to  their  depositor-borrowers. 

If  all  banks  w^ere  expanding  their  loans  at  the  same 
rate,  in  connection  with  simultaneous  additions  to 
their  reserves,  the  contention  would  be  valid.  But 
additions  to  the  reserves  of  a  banking  system,  except  in 
the  most  extraordinary  case,  are  made,  at  any  given 
time,  not  by  the  deposit  of  cash  simultaneously  in  all 
the  banks  of  a  system  but  by  the  deposit  of  funds  in 
only  a  small  proportion  of  the  banks,  w^hence  they  are 
scattered  throughout  the  system. 

In  the  usual  case  a  bank  receives  additions  to  its 
reserves  from  either  (1)  other  banks  in  the  system  or  (2) 


THE  PHILOSOPHY  OF  BANK  CREDIT  75 

from  sources  outside  the  banking  system — imported 
or  newly  mined  gold.  If  additional  cash  is  received  by 
any  banls:  from  sources  outside  the  system  that  circum- 
stance would  not  impel  other  banks  in  the  system  at 
once  to  expand  their  loans,  thereby  accommodatingly 
preventing  a  loss  of  cash  on  the  part  of  the  bank  whose 
reserves  had  been  augmented  and  whose  loans  had 
been  consequently  increased,  even  though  later  the 
other  banks  would  tend  to  expand  their  loans,  as  soon 
as  "overflow"  cash  fell  into  their  possession,  as  has 
been  explained. 

Likewise,  if  the  addition  to  the  reserves  of  an  indi- 
vidual bank,  bank  A,  came  from  some  other  bank  or 
banks  within  the  system,  that  circumstance  would 
tend  to  effect  a  contraction  in  the  loans  of  the  bank  or 
banks  losing  the  reserve,  and  instead  of  their  depositor- 
borrowers  drawing  more  checks  than  formerly,  as 
would  be  necessary  if  the  swollen  volume  of  checks 
drawn  on  bank  A  were  to  be  offset,  they  would  tend  to 
draw  less! 

Conclusively,  if  the  claims  of  the  Des  Moines  Na- 
tional Bank  upon  all  other  banks  and  the  claims  of  all 
other  banks  upon  the  Des  Moines  National  Bank 
balanced  and  cancelled  before  the  acquisition  by  that 
bank  of  a  certain  addition  to  its  reserves  and  prior  to  an 
expansion  of  loans  consequent  to  that  addition,  those 
claims  would  not  balance  and  cancel  after  the  loan  ex- 
pansion had  been  made  and  the  proceeds  drawn  upon 
by  the  borrowers,  the  checks  drawn  by  the  depositor- 
borrowers  and  remitted  to  their  creditors  placing  other 
banks  in  the  system  in  a  position  to  lay  claim  to  cash 
in  the  vaults  of  the  lending  institution. 


7G  BANK  CREDIT 

The  old  contention  that  no  cash  would  be  lost  by  the 
bank  that  increased  its  loans,  under  the  conditions 
given,  that  counterclaims  would  still  balance,  was  the 
fruit  of  confusing  the  operations  of  a  bank  with  the 
operations  of  a  banking  system.  Some  serious,  if  not 
surprising,  consequences  of  this  confusion  will  be 
dwelt  upon  in  chapter  five,  to  which  we  may  pass  either 
directly  or  by  way  of  chapter  four. 


CHAPTER  IV 

Inter-Relations  of  Cash,  Loans  and  Deposits 
Considered  Further 

The  preceding  chapter,  which  drew  a  sharp  Une  of 
distinction  between  loans  of  individual  banks  and  those 
of  the  banking  system,  has  paved  the  way  for  further 
consideration  of  certain  inter-relationships  of  items  of 
the  balance  sheet  in  both  individual  and  collective 
banking.  In  the  present  chapter  the  dynamic  inter- 
relations of  cash,  loans  and  deposits  will  be  taken  up; 
in  the  following  chapter,  surplus  in  relation  to  loans 
and  the  principal  creditor  HabiUties  will  be  discussed. 

Cash  in  Relation  to  Loan  Expansion  in  Individual  and 
Collective  Banking 

It  was  pointed  out  in  chapter  II  that  there  is  a  two- 
fold check  on  a  banker's  impulse  and  ability  to  in- 
crease his  profits  by  liberal  lending.  An  expansion  of 
loans  by  an  individual  bank  tends  to  cause  cash  to  fall 
and  deposits  to  rise,  the  rise  in  deposits  being  the  tem- 
porary forerunner  of  an  actual  loss  of  reserve — a  loss  of 
reserve,  albeit,  somewhat  less  than  the  loan  expansion, 
as  we  have  seen.  But  loss  of  cash  as  a  result  of  in- 
creased loans,  which  is  a  powerful  check  on  the  loan 
expansion  of  an  individual  bank,  tends  to  become 
inoperative  if  all  banks  within  a  credit  area  expand 
their  loans  with  equal  rapidity.    If  all  the  banks  in  a 

77 


78  BANK  CREDIT 

system^  are  increasing  their  loans  and  investments  at 
the  same  rate,  the  cash  of  any  one  bank  will  tend  to 
remain  constant.  This  is  true  because  (a)  direct  with- 
drawals of  cash  by  borrowers  from  any  one  bank  will  be 
offset  by  the  deposit  of  actual  cash  coming  from  other 
banks  into  the  hands  of  that  bank's  depositors,  and 
(b)  the  liberal  loan  policy  of  other  banks  will  place 
their  borro\\ing  customers,  who  are  at  the  same  time 
depositors,  in  a  position  to  draw  more  checks  than  pre- 
viously, which  in  due  proportion  will  be  sent  in  pay- 
ment of  obligations  to  the  customers  of  our  given  bank, 
where  they  will  be  deposited  and  used  instead  of  cash 
to  offset  checks  drawn  upon  that  bank  by  its  depositor- 
borrowers  and  forwarded  to  it  by  the  drawees  through 
the  established  channels  for  payment.  In  the  bank- 
ing system  as  a  whole  where  loans  (less  the  discount 
allowed  to  accumulate  as  undivided  profits  or  surplus) 
tend  to  result  in  deposits,  the  check  imposed  upon 
expanding  loans  by  the  direct  or  indirect  withdrawal 
of  cash  from  the  institutions  indulging  in  liberal  lend- 
ing is,  therefore,  inoperative.  The  cash  that  leaves  one 
bank  finds  a  resting  place  in  another.  If  the  reserve 
of  one  bank  is  reduced,  that  of  another,  or  of  others,  is 
augmented.  For  the  banking  system  as  a  whole,  the 
only  check  on  expanding  loans  is  that  represented  by 
swelling  deposit  liabilities.^ 

1  By  system  of  banks  is  meant  not  the  banks  operating  under  the 
authority  of  a  given  law  or  laws,  as  the  national  banks  or  state 
banks,  but  banks  united  by  the  ties  of  cash  and  credit  relationships. 

2  It  is  not  overlooked  of  course  that  an  over-extension  of  deposit 
liabilities  would  tend  to  cause  a  rise  in  prices  and  an  exportation  of 
gold — a  fact  that  has  little  significance  in  this  immediate  connection, 


INTER-RELATIONS  OF  CASH,  LOANS  AND  DEPOSITS    79 

Regulation  of  Ratio  of  Cash  to  Deposits  in  Individual 
Banking 

When  a  certain  more  or  less  normal  or  representative 
ratio  of  cash  to  deposits  has  been  reached  in  the  life 
history  of  a  bank,  that  is,  when  the  individual  bank  has 
become  assimilated  to  the  banking  system  of  which  it  is 
a  part,  the  ratio  of  cash  to  deposits  is  regulated  and 
kept  fairly  constant  through  the  banker's  control  over 
cash.  If  the  banker's  cash  falls  below  what  he  regards 
as  the  line  of  safety  in  relation  to  possible  cash  demands 
of  depositors,  including  both  direct  and  indirect  with- 
drawals, new  loans  are  curtailed  or  discontinued  until 
the  inflow  of  cash  coming  from  maturing  loans  has  re- 
stored the  ratio  of  cash  to  deposits  to  proper  or  de- 
sired proportions.  If  the  demand  for  loans  falls  off 
locally  and  cash  accumulates  excessively,  new  outlets 
for  the  idle  and  redundant  reserve  are  sought  in  out- 
of-town  loans  or  in  investments  other  than  promissory 
notes.  ^ 

If,  on  the  contrary,  the  ratio  of  cash  to  deposits 
becomes  too  much  attenuated,  the  banker,  always 
eager  to  maintain  and  even  to  increase  the  volume  of 
his  dep9sits,  will  try  to  restore  the  ratio  to  normality 

however.  The  outflow  of  gold  which  would  tend  to  check  further 
loan  and  deposit  expansion  at  home  would  tend,  by  the  same  token, 
to  cause  an  expansion  of  the  loan  and  deposit  items  in  banks  abroad. 

Also  see  note,  page  39. 

*  The  rate  of  interest  is  frequently  lowered  in  order  to  equate 
supply  and  demand  in  the  loan  market,  but  the  wide-spread  practice 
is  to  maintain  the  over-the-counter  rate  on  customers'  paper  rather 
inflexibly  and  to  accept  whatever  rate  can  be  got  for  funds  placed  iu 
the  outside  market. 


80  BANK  CREDIT 

by  adding  to  his  holdings  of  cash  through  curtailment 
of  loans  rather  than  by  seeking  a  reduction  in  deposits, 
for  the  withdrawal  of  deposits  would  tend  to  reduce 
cash  correspondingly.  Althougli  the  correction  of  the 
ratio  of  cash  to  deposits  when  cash  is  low  in  relation  to 
deposit  liabilities  tends  to  cause  a  slight  reduction  in 
deposits,  occasioned  by  the  curtailment  of  loans,  that 
reduction  occurs  against  the  will  of  the  bank  manage- 
ment. The  banker  tries  to  increase  his  cash,  when  it 
gets  low^,  without  causing  a  reduction  of  deposits,  but 
his  action,  in  spite  of  his  desire  and  effort  to  avoid  the 
result,  inevitably  tends  to  lessen  the  deposit  item.  Call- 
ing loans  and  refusing  to  make  new  commitments  to 
offset  maturing  paper  tends  to  cause  the  individual 
banker's  cash  to  increase  and  his  deposits  shghtly  to 
decline. 

The  individual  banker's  regulative  or  corrective 
power  over  the  ratio  of  reserve  to  deposits  is  exercised, 
it  is  clear,  through  increasing  or  curtailing  loans.  The 
amount  of  his  reserve  in  relation  to  demand  liabilities 
at  any  given  time  will  determine  the  advisability  of 
lending  more  freely,  thereby  reducing  cash  and  in- 
creasing deposits,  or  of  lending  less  freely,  thereby 
causing  cash  to  accumulate  and  deposits  to  fall  off. 
The  banker's  control  over  the  cash-deposits  ratio  passes 
through  the  loan  item  as  a  medium  of  transmission. 

The  condition  that  is  marked  by  the  growth  of  cash 
in  the  vaults  of  a  bank,  and  by  declining  loans  and 
deposits  when  loans  are  being  curtailed,  and  the  con- 
dition that  is  marked  by  falling  cash  and  rising  depos- 
its, when  cash  has  become  disproportionately  large  in 
relation  to  deposit  liabilities  and  loans  are  consequently 


INTER-RELATIONS  OF  CASH  LOANS  AND  DEPOSITS    81 

being  expanded, — both  these  conditions  are  constantly- 
subject  to  correction.  One  day  or  one  week  or  even 
month  the  banker  lends  or  buys  commercial  paper 
freely,  and  the  next  day  or  next  week  or  month  trims 
his  sails.  The  banker's  cash-deposit  ratio  at  the  close 
of  business  today  dictates  the  contraction  or  expansion 
of  his  loans  tomorrow.  Through  his  loan  item  the 
banker  regulates  the  amount  of  his  cash  and,  to  some 
extent,  of  his  deposits.  Adjustment  and  correction  of 
the  ratio  of  cash  to  deposits  are  almost  continuous. 

A  pertinent  question  arises  at  this  point.  If  the 
banker,  finding  his  deposit  liabilities  dangerously 
large  in  relation  to  cash — as  he  sometimes  does  after 
paying  an  unexpectedly  heavy  balance  to  the  clearing 
house — proceeds  to  replenish  his  reserves  by  calling 
or  curtailing  loans,  do  not  the  deposits  of  an  indi\adual 
bank  regulate  cash?  The  answer  is  that  for  the  indiv- 
idual bank  in  question  the  ratio  which  the  bank 
management  regards  as  being  in  the  highest  degree 
prudent  and  profitable  has  become  distorted  or  dis- 
turbed. The  bank  management,  with  no  desire  to 
reduce  its  deposits,  deems  it  desirable  to  increase  its 
cash.  Curtailment  of  loans,  which  is  productive  of 
augmented  reserve,  inevitably  tends  to  effect  a  reduc- 
tion of  deposits.  The  restoration  of  the  ratio  of  cash 
to  deposits  entails,  then,  a  reduction  in  deposits  and 
loans  as  well  as  an  increase  in  cash,  mutual  determin- 
ism existing  between  the  reserve  and  deposits.  The 
motive  force  underlying  the  restoration  of  the  ratio 
under  this  condition  is  the  banker's  fear  that  he  may 
be  unable  to  meet  his  demand  liabilities,  or  else  an  un- 
wilUngness  to  evade  legal  reserve  requirements. 


82  BANK  CREDIT 

But  suppose  the  reserves  of  an  individual  bank 
are  excessive  in  relation  to  deposits.  Under  this 
condition  not  fear  or  prudence  or  respect  for  banking 
law,  but  desire  for  greater  profit  becomes  the  motive 
underlying  the  correction  or  restoration  of  the  reserve- 
deposits  ratio,  and  the  bank  will  increase  its  loans 
until,  as  pre\'iously  pointed  out,  the  combined  force 
of  impaired  cash  and  enlarged  deposits  calls  a  halt. 
The  increase  in  the  individual  banker's  loans  is  limited 
by  both  a  reduction  in  cash,  which  tends  to  take  place 
as  long  as  his  loans  are  increasing,  and,  to  a  shght  ex- 
tent, by  the  increasing  deposits  resulting  from  the 
rising  loans.  It  is  not  merely  cash  in  the  vaults  of  the 
individual  bank  that  impels  the  banker  to  expand  his 
loan  item,  but  cash  in  relation  to  deposits.  Both  terms 
of  the  cash-to-deposits  ratio  are  variable  in  the  indi- 
vidual bank  and  tend  to  be  affected  in  opposite  direc- 
tions, but  not  necessarily  to  the  same  degree,  when 
loans  are  expanded  or  curtailed.  For  the  indi\ddual 
bank  that  has  become  assimilated  to  the  system  cash 
and  deposits  are  mutually  determinative,  and  both  are 
regulated  by  loans.  Increase  loans,  cash  goes  down 
and  deposits  go  up.  Reduce  loans,  cash  increases  and 
deposits  fall  off. 

Ratio  of  Cash  to  Deposits  and  to  Loans  in  the  Banking 
System 

The  relationship  between  cash  and  deposits  and 
between  cash  and  loans  in  an  individual  bank  is  very 
different  from  the  same  in  the  banking  system  re- 
garded as  an  aggregate.  In  the  banking  system,  at 
any  stage  of  banking  development,  deposits  and  loans 


INTER-RELATIONS  OF  CASH,  LOANS  AND  DEPOSITS    83 

are  a  function  of  cash.^  An  increase  of  cash  in  the 
banking  system  tends  to  be  followed  by  a  manifold 
increase  in  loans,  the  proceeds  of  which  cause  the 
deposits  of  the  system  to  swell  in  approximately  the 
same  proportion  as  the  loans.  An  increase  in  the  cash 
of  an  individual  bank,  on  the  other  hand,  does  not 
result  in  an  increase  in  its  loans  and  deposits  equal  to 
several  times  the  amount  of  the  new  cash,  but  in  a 
loan  and  deposit  increase  of  scarcely  more  than  the 
amount  of  the  new  cash.  If  an  attempt  were  made  by 
an  individual  bank  to  lend  an  amount  equal  to  several 
times  the  cash  newly  acquired,  unfavorable  clearing 
house  balances  and,  perhaps,  withdrawals  of  cash  over 
the  counter,  would  in  a  short  time  reduce  the  cash  of 
the  bank  below  the  hne  of  safety, — a  fact  with  which 
we  are  already  familiar. 

1  There  is  a  measure  of  mutual  determinism  between  cash  and 
deposits  in  the  banking  system  considered  as  a  whole.  An  increase 
of  cash  in  the  banking  system  tends  to  cause  loans  and  deposits  to 
increase.  An  increase  in  deposits,  whether  induced  by  an  expansion 
in  the  money  metal  mined  or  by  a  fall  in  the  ratio  of  cash  to  deposits, 
tends  to  check  the  output  of  money  metal  through  rising  general  prices. 
On  the  other  hand,  if  cash  were  to  fall  off  in  relation  to  trade,  or  if 
the  cash-deposits  ratio  rose,  a  consequent  lower  general  price  level 
would  tend  to  stimulate  the  production  of  gold.  Whatever  the 
degree  of  mutual  determinism  between  cash  and  deposits,  in  the 
banking  system  as  a  whole,  the  action  of  the  forces  there  at  work  is 
exceedingly  slow  in  comparison  with  the  action  of  the  forces  that 
determine  the  relationship  between  cash  and  deposits  in  the  in- 
dividual bank. 


CHAPTER  V 

SuBPLUs  IN  Relation  to  Loans,  Deposits  and 

Reseeves 

Probably  no  phase  of  banking  has  been  treated  so 
inadequately  and  erroneously  as  has  surplus,  its 
nature,  functions  and  relation  to  other  items  in  the 
bank  balance  sheet.  The  defective  treatment  has  been 
traceable  measurably  to  factors  already  referred  to 
in  chapter  II.  Recently,  however,  in  perhaps  the 
most  elaborate  attempt  at  exposition  and  elucidation 
yet  put  forth,  that  of  Professor  Moulton,^  still  other 
considerations,  with  roots  running  deep  into  a  tradi- 
tional and  current  but  nevertheless  erroneous  theory 
of  banking,  invalidate  the  main  doctrine  advanced, 
namely,  that  the  accumulation  of  surplus  in  commer- 
cial banking  tends  to  weaken  the  position  of  depositors, 
to  reduce  the  chance  of  the  ultimate  redemption  of 
deposits.  An  examination  of  this  doctrine,  which  Pro- 
fessor Moulton  develops  skillfully,  will  serve  as  an 
introduction  to  a  positive  statement  of  relationship 
between  surplus  and  loans,  deposits,  cash. 

A  New  but  Erroneous  Doctrine  of  Surplus 

Professor  Moulton  uses  as  an  instrument  of  exposi- 
tion a  condensed  balance  sheet  of  a  bank,  reminding 

1  Harold  G.  Moulton,  The  Surplus  in  Commercial  Banking,  Jour- 
nal of  Political  Economy,  December,  1917,  Vol.  25,  pp.  1003-1018. 

84 


SURPLUS  IN  RELATION  TO  LOANS,  ETC.    85 

us  that  deposits  arise  out  of  loans  and  that  the  two 
magnitudes  are,  in  the  banking  system  as  a  whole, 
approximately  equal.  The  simplified  balance  sheet 
from  which  his  argument  proceeds  is  as  follows : 

Assets  Liabilities 

Cash $100,000    Capital  Stock $100,000 

Loans 500,000    Deposits 480,000 

Interest  and  Discount 
Collected 20,000 

It  is  correctly  observed  by  Professor  Moulton  that 

The  ratio  of  cash  to  deposits  in  the  statement  just  given  is 
20.8  per  cent.  The  ratio  of  assets  to  deposits,  and  hence  the 
chance  of  ultimate  liquidation,  is  $500,000  (loans)  +  $100,000 
(cash)  —  a  total  of  $600,000  —  $480,000  (deposits),  or 
60  :  48  =  5  :  4. 

As  time  passes  the  same  bank  accumulates  a  surplus 
of  $20,000,  which  is  assumed  by  Professor  Moulton  to 
be  initially  in  the  form  of  cash,  accumulated  from  earn- 
ings.^ 

Whether  it  is  admissible  to  proceed  on  the  assump- 
tion that  surplus  is  represented  by  cash  is  a  question 
that  will  be  answered  later.  We  may  now  advanta- 
geously reproduce  the  following  passages  as  containing 

1  "Of  course  in  actual  practice,"  says  Professor  Moulton,  "the 
amount  set  aside  as  surplus  is  not  represented  by  a  like  amount  of 
cash  that  is  not  utilized  until  semi-annual  dividend  date.  The 
process  of  investing  'surplus  funds'  is  a  continuous  one  and  not 
semi-annual.  For  clearness  of  exposition,  however,  it  is  better  to 
assume  that  surplus  is  represented  by  cash  and  that  its  investment 
follows  rather  than  precedes  the  formal  setting  aside  of  such  a  fund." 
Op.  cit.,  p.  10-11. 


SG  BANK  CREDIT 

the  kernel  of  Professor  Moulton's  contention  that  the 
accumulation  of  a  surplus  tends  to  impair  the  chance 
of  the  ultimate  payment  of  creditor  liabihties. 

The  same  bank  {i.  e.,  the  bank  whose  balance  sheet  was 
last  given)  in  time  accumulates  a  surplus  of  $20,000.  Let  us 
assume  that  the  $20,000  represented  by  surplus  is  initially 
in  the  form  of  cash,  having  been  accumulated  from  earnings. 
On  the  basis  of  this  new  cash  the  bank  now  proceeds  to  ex- 
pand its  business  by  making  additional  loans.  As  a  going 
concern  it  would  then  shortly  present  the  following  balance 
sheet. 

Assets  Liabilities 

Cash $120,000    Capital  Stock $100,000 

Loans 600,000    Surplus 20,000 

Deposits 576,000 

Interest  and  Discount 

CoUected 24,000 

The  ratio  of  cash  to  deposits  is  still  20.8  per  cent.  The 
ratio  of  assets  to  deposits,  and  hence  the  chance  of  ultimate 
liquidation,  is  $600,000  (loans)  +  $120,000  (cash)  —  a  total 
of  $720,000  —  to  $576,000  (deposits),  or  720  :  576  =  5  :  4, 
the  same  as  before  the  surplus  was  created.  Resources  have 
increased,  it  is  true,  but  since  deposit  liabilities  increased  at 
the  same  rate  the  chances  of  the  creditors  being  paid  in  full 
are  no  whit  different  from  what  they  were  without  a  surplus. 

In  fact,  the  depositors  have  a  smaller  chance  of  being  paid 
iQ  full  than  was  the  case  before  the  surplus  was  created,  for 
the  reason  that  our  banking  laws  provide  that  shareholders 
are  doubly  liable  on  capital  stock,  but  not  on  account  of  sur- 
plus. When  measuring  the  ultimate  securitj^  of  creditors  this 
factor  must  be  included.  Correcting  the  foregoing  ratios  of 
assets  to  creditor  liabilities  by  including  the  double  Hability  of 
shareholders  on  capital  stock  we  have,  before  the  creation 


SURPLUS  IN  RELATION  TO  LOANS,  ETC.    87 

of  a  surplus,  S500,0G0  (loans)  +  $100,000  (cash)  +  $100,000 
(double  liability  on  capital  stock)  =  $700,000  —  to  $480,000 
=  35  :  24  or  1.458  to  1.  In  the  second  case  it  becomes 
$600,000  (loans)  +  $120,000  (cash)  +  $100,000  (double 
liability  on  capital  stock)  =  $820,000  —  to  $576,000  = 
205  :  146,  or  1.404  to  1  —  less  than  when  there  was  no  surplus 
account  at  all.  It  may  be  concluded  therefore  that  rather 
than  strengthening  the  position  of  the  depositor  the  creation 
of  a  surplus  really  tends  to  weaken  it.^ 

It  is  granted  that  of  the  bank  statements  reproduced 
from  Professor  Moulton's  article  the  first  shows  a 
greater  degree  of  protection  to  depositors  than  does 
the  second.  T^Tiether  the  accmnulation  of  a  surplus 
would  result  in  the  condition  indicated  by  the  second 
statement  is  the  crucial  question. 

The  Doctrine  Disproved 

In  what  follows  it  will  be  shown  that  the  accumula- 
tion of  a  surplus  neither  in  an  indi\'idual  bank  nor  in 
the  banking  system  as  a  whole  results  in  such  an  in- 
crease in  cash^  and  deposits  as  to  neutralize,  to  say 
nothing  of  outweighing,  the  enhanced  safety  that  the 
accumulation  of  surplus  affords  to  depositors.  We 
may  consider  first  the  case  of  an  individual  bank. 

Let  us  assume,  pro  argumento,  that  it  is  practicable  for 
an  individual  bank  to  set  aside  as  surplus  an  amount  of 
earnings  represented  specifically  by  a  like  amount  of 
cash, — a  basic  assumption  made  by  Professor  Moul- 
ton, — and  proceeding  on  that  assumption,  inquire 
whether  a  surplus  thus  represented  by  cash  generates  r 

^Op.cit.,  pp.  1011,  1012. 

2  Cash  is  used  in  this  chapter  synonomously  with  reserve. 


88  BANK  CREDIT 

several-fold  expansion  of  loans  and  deposits  in  the  man- 
ner described  in  the  excerpts  reproduced  on  pages  86,  87. 

It  was  shown  in  a  preceding  chapter  that  the  ac- 
cumulation of  surplus  represented  by  an  addition  of  a 
given  amount  of  cash  to  the  reserves  of  an  individual 
bank  would  enable  that  bank  typically  to  expand  its 
loans  by  an  amount  approximately  equal  to,  or  some- 
what in  excess  of,  the  new  cash.  It  was  also  shown  in 
the  same  chapter  that  new  loans  made  tend  to  cause 
the  bank  extending  the  credit  to  lose,  on  the  average, 
an  amount  of  reserve  only  somewhat  less  than  the 
amount  of  the  loans.  The  addition  of  $20,000  to  the 
surplus  and  to  the  cash  would  place  the  bank  concerned 
in  a  position  to  add  $24,390.24^  to  its  previous  volume 
of  loans,  if  derivative  deposits  of  the  bank  average  20 
ptir  cent  of  its  loans  and  a  reserve-deposits  ratio  of  10 
per  cent  is  maintained.  Such  an  increase  in  loans 
would  tend  to  result  in  the  withdrawal  of  cash  equal  to 
$19,512.20,  leaving  $487.80  as  a  10  per  cent  reserve  to 
support  derivative  deposits  of  $4,878.05,  i.  e.,  20  per 
cent  of  the  additional  loans. 

It  is  important  to  observe  that  the  surplus  ''repre- 
sented by  cash"  ceases  to  be  represented  by  cash  as 
soon  as  loans  are  expanded  on  the  basis  of  the  cash. 
The  surplus  remains,  but  the  cash  largely  leaves  to 
meet  unfavorable  clearing  balances.  The  very  act  of 
utilizing  the  cash  as  a  basis  of  loans  causes  its  fugitive 
character  to  assert  itself,  with  the  result  that  loans  are 
increased  appreciably,  deposits  are  increased  slightly 
and  cash,  the  earmarked  cash  that  stood  for  the  sur- 
plus, is  very  decidedly  reduced. 
1  See  page  71. 


SURPLUS  IN  RELATION  TO  LOANS,  ETC.    89 

It  must  be  clear  that  as  long  as  the  surplus  was 
represented  by  cash  it  afforded  additional  protection 
to  depositors  and  other  general  creditors.  It  must  also 
be  clear  that  when  the  surplus  ceased  to  be  represented 
by  cash  and  that  very  cash,  as  a  result  of  loan  expan- 
sion, largely  took  flight  to  other  banks,  precluding  the 
possibihty  of  a  deposits  expansion  equal  to  several 
times  the  amount  of  the  surplus  represented  by  cash, 
the  surplus  still  remained  intact.  That  is,  the  accumu- 
lation of  a  surplus  represented  by  cash  or  not  so  repre- 
sented does  furnish  additional  protection  to  depositors, 
does  improve  the  chances  of  the  ultimate  redemption 
of  creditor  liabilities  in  the  case  of  an  individual  bank. 

Having  shown  that  the  accumulation  of  a  surplus 
by  an  individual  bank  tends  to  improve  the  chance 
of  the  ultimate  redemption  of  deposits,  we  have  now 
to  consider  the  way  in  which  the  accumulation  of  a 
surplus  affects  the  safety  of  deposits  and  other  creditor 
items  in  the  hanking  system  as  a  whole. 

Is  there  anything  connected  with  the  action  of  bank 
directors  in  building  up  surplus — at  the  expense  of 
dividend  payments — that  would  swell  the  amount  of 
cash  in  a  banking  system?  Would  the  diversion  of 
earnings  from  dividends  to  surplus  accelerate  the  pro- 
duction of  gold,  or  swell  the  volume  of  our  legal  tender 
notes,  or  even  prompt  the  managements  of  our  Federal 
Reserve  banks  to  adopt  a  more  liberal  policy  with 
reference  to  note  issues?  Would  the  accumulation  of 
a  surplus  cause  business  men  and  concerns  and  the 
general  public  to  substitute  checks  for  cash  in  making 
payments  ordinarily  and  conveniently  made  with 
cash,  to  such  an  extent  as  to  effect  a  balance  between 


90  BANK  CREDIT 

surplus  accumulating  and  the  additional  reserve? 
WTiat  would  attract  the  cash  from  circulation  into  the 
banks?  Not  surplus  ''represented  by  cash,"  because 
such  surplus  would  not  come  into  being  until  the  corre- 
sponding cash  had  come  into  the  banks!  It  is  inad- 
missible to  assume  that  surplus  accumulated  in  a 
banking  system  is  represented  by  so  much  additional 
cash,  because  there  is  no  creative  connection  between 
the  accumulation  of  surplus  and  the  cash  that  is  as- 
sumed to  correspond  to  that  surplus.  If  the  newly 
created  surplus  is  not  represented  by  additional  cash 
\^  ithin  the  banking  system,  additional  deposits  within 
the  banking  system  could  not  be  built  up  without  re- 
ducing the  cash-deposits  ratio  of  the  system. 

What  actually  takes  place  in  a  banking  system  when 
surplus  is  accumulated  may  be  made  clear  by  resort 
to  the  consolidated  balance  sheet  of  all  our  banks 
taken  in  the  aggregate.  The  following  simphfied 
and  condensed  balance  sheet  represents  roughly  the 
aggregate  condition  of  the  commercial  banks  of  the 
United  States  as  given  in  the  report  of  the  Comptroller 
of  the  Currency  for  1918. 

Assets  Liabilities 

Loans $32  billions    Capital $2.3  billions 

Reserve 3      "  Surplus 2. 

Undivided  Profits. .      .7      " 
Deposits 30.        " 

$35  billions  $35  billions 

If  a  surplus  of  1  billion  is  now  accumulated  in  the 
course  of  a  year,  let  us  say,  that  procedure  would  not 
cause  bank  managements  to  reduce  deposits  in  rela- 


SURPLUS  IN  RELATION  TO  LOANS,  ETC.    91 

tion  to  cash.  Such  a  reduction,  if  it  is  assumed  to  take 
place,  would  be  favorable  to  the  ultimate  redemption  of 
creditor  liabilities.  The  accumulation  of  additional 
surplus  amounting  to  1  bilUon  would  neither  increase 
nor  diminish  cash^although  cash  might  increase  or 
decrease  during  a  given  period  of  time  on  account  of 
otiier  factors.  If  cash  remains  stationary  and  deposits 
do  not  fall  off  as  a  result  of  the  accumulation  of  surplus, 
the  cash-deposits  ratio  remaining  unchanged,  it  is 
obvious  that  loans,  in  the  simplified  balance  sheet, 
must  increase  by  the  amount  of  the  sui-plus,^  and  the 
statement  of  condition  will  now  stand  as  follows: 

Assets  Liabilities 

Loans $33  billions    Capital $2.3  billions 

Cash 3       "         Surplus 3. 

Undivided  Profits..     .7      " 
Deposits 30.         " 

$36  billions  $36      billions 

Since  deposits  have  remained  stationary  and  the 
excess  of  assets  over  liabilities  other  than  those  due 
shareholders  has  increased  by  1  bilUon  dollars,  the 
ultimate  chance  of  deposit  redemption,  as  measured 
by  that  excess,  has  been  enhanced. 

Professor  Moulton's  contention  that  the  accumula- 
tion of  a  surplus  tends  to  weaken  the  position  of  de- 

*  A  similar  principle  applies  to  surplus  paid  in  or  capital  paid  in. 
The  shareholders  in  drawing  checks  with  which  to  pay  their  sub- 
scriptions tend  to  reduce  deposits  in  the  system.  But  such  a  reduc- 
tion of  deposits  is  only  temporary.  Additional  loans  tead  to  result 
in  a  reestabliahment  of  the  nonnal  cash-deposits  ratio. 


92  BANK  CREDIT 

posit  ors  is  centered  around  the  balance  sheet  of  an 
individual  bank,  even  though  his  own  injunction  is  to 
emphasize  the  banking  system  as  a  whole  as  distinct 
from  individual  banks  as  units  in  that  system.  It 
will  therefore  be  well  to  observe  that  the  creation 
by  an  indi\ddual  bank  of  a  surplus  "represented  by 
cash"  would  tend  to  necessitate  a  reduction  of  cash 
somewhere  else  in  the  banking  system.  The  loss  of 
cash  by  other  banks  in  the  system  would  correspond 
roughly  to  that  gained  by  the  bank  creating  a  surplus 
''represented  by  cash."  Expansion  and  contraction 
in  the  loans  and  deposits  of  a  banking  system  are 
regulated  by  the  cash  reserve  of  the  system.  If  the 
cash  is  shifted  from  bank  to  bank,  or  from  center  to 
center,  the  expansion  and  contraction  of  loans  and  de- 
posits also  tend  to  shift.  If  the  creation  or  accumula- 
tion of  a  surplus  represented  by  cash  takes  place  at  one 
point  in  the  banking  sj^stem  some  other  point  or  points, 
ceteris  paribus,  will  have  been  forced  to  curtail  their 
operations,  reducing  their  loans  in  order  to  keep  their 
ratio  of  cash  to  deposits  within  the  customary  limits 
of  banking  prudence.  A  swell  in  the  cash,  loans,  and 
deposits  in  one  quarter  where  surplus  represented  by 
cash  was  being  built  up  would  be  offset  by  a  corre- 
sponding depression  in  loans  and  deposits  in  other 
quarters  whence  cash  was  being  withdrawn. 

If  within  a  banking  system  siuplus  goes  up  at  a 
point  gaining  cash  and  down  at  the  point  or  points 
losing  cash,  the  net  result  would  be,  obviously,  no 
change  in  surplus.  If,  within  a  banking  system,  surplus 
goes  up  at  a  point  gaining  cash  and  does  not  go  down 
at  the  point  or  points  losing  cash,  the  net  result  would 


SURPLUS  IN  RELATION  TO  LOANS,  ETC.   93 

be  an  increase  in  the  ratio  of  surplus  to  deposits.  In 
one  case  the  surplus  in  the  system  does  7iot  increase;  in 
the  other,  surplus  in  the  system  increases  but  deposits 
do  not.  Evidently,  if  surplus  increases  in  the  banking 
system  as  a  whole  and  deposits  and  other  creditor 
liabilities  do  not,  the  chance  of  the  ultimate  payment 
of  creditor  liabilities  is  enhanced. 

Whether  the  accumulation  of  a  surplus  is  considered 
in  connection  with  an  individual  bank  or  in  connection 
with  the  banking  system  as  a  whole,  it  is  now  plain 
that  the  chance  of  the  ultimate  redemption  of  creditor 
liabilities  is  improved  by  accretions  to  the  surplus  item. 

WTiat  then  is  Professor  Moulton's  fundamental 
error?  It  is  two-fold.  In  the  first  place,  he  assumes 
that  an  individual  bank  can  increase  its  loans  by  several 
times — five  times — the  amount  of  its  surplus  reserve 
without  losing  cash  to  other  banks  in  the  system, — a 
mistaken  contention  that  is  traceable  to  his  failure  to 
distinguish  carefully  between  the  operations  of  an  iso- 
lated bank,  that  would  not  lose  cash  as  a  result  of  loan 
expansion,  and  the  operations  of  a  bank  that  is  only 
one  of  many  units  in  a  banking  system,  where  loan  ex- 
pansion tends  to  result  in  a  loss  of  cash  by  the  bank 
whose  loans  are  expanding.^  This  lack  of  clearness  of 
distinction  between  individual  and  collective  banking 
Ues  at  the  root  of  the  fallacy  that  permeates  his  dis- 
cussion. 

The  second  error,  namely,  his  assumption  that  the 
accumulating  surplus  of  a  hanking  system  may  be  repre- 
sented by  cash,  dovetails  with  the  first  and  is  scarcely 
less  subtle  and  misleading.  If  the  accumulation  of 
1  See  pages  37,  38. 


94  BANK  CREDIT 

surplus  in  a  banking  system^  brought  into  being  a 
corresponding  accretion  to  the  cash  of  the  system,  de- 
posits in  the  system  would  tend  to  expand  as  indicated 
in  the  statements  quoted  on  pages  85,  86  and  the 
accumulation  of  surplus  would  tend  to  lessen  the 
chances  of  the  ultimate  redemption  of  creditor  liabili- 
ties. But  the  accumulation  of  a  surplus  does  not  bring 
into  being  any  corresponding  accretion  to  cash,  as  we 
have  seen. 

The  Relation  of  Cash  or  Reserve  to  Surplus 

There  is  a  causal  connection  between  cash  or  reserve 
and  surplus,  but  the  direction  of  the  connecting  forces 
is  from  reserve  to  surplus  through  deposits,  and  not  from 
surplus  to  reserve.  An  accretion  of  cash  or  reserve  to 
that  of  the  banking  system  tends  to  be  followed  by  a 
several-fold  increase  in  deposits  in  the  banking  system, 
as  we  have  seen;  and  an  increase  in  deposits  tends  to  be 
followed  by  an  increase  in  surplus. 

The  larger  the  deposits  in  any  individual  bank,  the 
larger  will  be  the  loans  and  investments  and,  therefore, 
the  earnings  from  which  surplus  may  be  accumulated. 
Not  only  do  larger  deposits  make  it  feasible  to  accumu- 
late surplus,  but  they  also  make  the  accumulation 
desirable  from  the  standpoint  of  the  management  and 
shareholders.     As  surplus  strengthens  the  assurance 

1  Although  Professor  Moulton  employs  the  balance  sheet  of  an 
individual  bank  as  an  aid  in  exposition,  he  enjoins  the  reader  to 
emphasize  the  banking  system  as  a  whole.  "This  emphasis,"  he 
says,  "is  necessary,  for  it  is  only  by  a  study  of  the  whole  rather  than 
of  the  individual  parts  that  one  can  obtain  an  adequate  understand- 
ing of  banking  organization."    Op.  cit.,  p.  1011. 


SURPLUS  IN  RELATION  TO  LOANS,  ETC.    95 

of  the  ultimate  convertibility  of  deposits  in  the  case  of 
any  given  bank,  a  large  surplus  in  relation  to  creditor 
liabilities  should  and  does  prove  attractive  to  both 
actual  and  potential  depositors.  A  relatively  large 
surplus  is  probably  more  influential  in  determining  the 
choice  of  correspondents  by  banks  than  in  connection 
with  the  choice  of  a  bank  by  a  business  house. 

Banks  that  borrow  from  their  city  correspondents, 
as  do  many  of  our  institutions,  particularly  in  the  South 
and  West,  are  able  to  borrow  more  liberally  and,  per- 
haps, at  more  favorable  rates  when  the  shareholders' 
equity  in  the  assets  of  their  bank,  as  represented  by 
capital,  surplus  and  undivided  profits,  is  large. 

Large  loans,  which  are  almost  invariably  associated 
with  large  deposits,  then,  make  the  accumulation  of  a 
surplus  easy  and  the  dictates  of  sound  and  profitable 
banking  make  its  accumulation  desirable.  The  larger 
the  deposits  the  larger  tends  to  be  the  surplus.  In  the 
banking  system  as  a  whole,  cash  regulates  deposits  and 
deposits  regulate  surplus.  Cash,  therefore,  regulates 
surplus.  The  relation  of  cash  to  surplus  in  the  banking 
system  may  be  represented  accurately  by  the  following 
simple    diagram. 

Cash      >      deposits      >      surplus 

The  regulatory  relation  of  cash  or  reserve  to  surplus 
is  loose  and  elastic,  but  of  such  a  nature  that  in  no  case 
would  an  increase  in  surplus  result  in  an  increase  in 
cash.  If  the  ratio  of  reserves  to  deposits  and  that  of 
surplus  to  deposits  (which  constitute  the  bulk  of 
creditor  liabilities)  remained  constant,  an  increase  in 
cash  would  be  accompanied  by  an  increase  in  surplus 


96  BANK  CREDIT 

in  direct  proportion.  Also  if  both  ratios  changed  at 
the  same  rate  and  in  the  same  direction,  any  change  in 
cash  would  be  accompanied  by  an  exactly  correspond- 
ing change  in  surplus.  In  American  banking  during 
the  last  generation  the  two  ratios  have  changed  in  the 
same  direction,  but  not  at  the  same  rates.  The  ratio  of 
reserves  to  deposits  in  our  national  banks  was  23.6  per 
cent  in  1885,  17  per  cent  in  1910,  and  10.4  per  cent  in 
1918.  The  ratio  of  surplus  and  undivided  profits  to 
creditor  liabilities  was  12  per  cent  in  1885,  11  per  cent 
in  1910,  and  7.5  per  cent  in  1918.^  The  two  items,  cash 
and  surplus,  including  undivided  profits,  were  roughly 
equal  in  1875  and  a  considerable  degree  of  parallelism 
has  continued  to  the  present  time. 

The  Ratio  of  Cash  to  Deposits  and  of  Surplus  to  Creditor 

Liabilities 

If  surplus — and  we  might  also  include  the  other 
protective  items,  capital  and  undivided  profits — is  not 
represented  by  reserve,  how  can  we  explain  this  strong 
tendency  toward  direct  variation  between  the  two 
items?  The  explanation  lies  in  the  fact  that  substan- 
tially the  same  or  similar  forces  effect  changes  in  both 
ratios. 

One  of  these  forces,  affecting  both  ratios,  consists  in 
the  banker's  conservatism.  If  a  representative  bank 
management  becomes  more  conservative  concerning 
the  immediate  convertibiUty  of  deposits,  that  same 
management  would  scarcely  be  expected  to  become 
less  so  with  reference  to  the  ultimate  convertibility  of 

1  Reports  of  the  Comptroller  of  the  Currency,  1885,  1910,  1918. 


SURPLUS  IN  RELATION  TO  LOANS,  ETC.    97 

those  deposits  and  other  creditor  liabilities.  Increas- 
ing conservatism  and  prudence  as  to  cash  tends  to  be 
matched  by  increasing  conservatism  as  to  smplus. 
Individual  cases  of  increasing  caution  and  prudence  as 
to  cash  and  the  reverse  as  to  surplus  are  probably  rare 
and  fully  offset  by  cases  of  dwindling  caution  and  pru- 
dence as  to  surplus  and  the  reverse  as  to  cash.  Con- 
servatism is  a  factor,  then,  that  affects  the  ratios  of 
cash  to  deposits  and  of  surplus  to  creditor  liabilities 
unequally,  nevertheless  in  the  same  direction.  It  is,  of 
course,  not  denied  that  the  maintenance  of  a  surplus, 
always  represented  largely  by  productive  assets, 
would  seem  to  go  less  strongly  against  the  grain  of  a 
typical  bank  management,  whose  prime  aim  is  always 
profit,  than  would  the  maintenance  of  a  large  and 
"barren"  reserve. 

Besides  the  banker's  prudence  and  conservatism  or 
caution  there  is  a  group  of  forces,  arising  out  of  the 
economic  and  banking  organization,  that  tends  to  keep 
the  ratio  referred  to  on  an  even  keel .  Certain  changes 
taking  place  in  the  evolution  of  our  economic  organi- 
zation, such  as  improvements  in  transportation  facili- 
ties, quickened  means  of  communication,  the  cen- 
traUzation  of  banking  reserves  and  the  creation  of 
improved  rediscount  facilities  admit  of  a  certain  re- 
duction in  the  percentage  of  reserves  without  any  im- 
pairment of  immediate  convertibiUty  of  deposits.  If 
improvement  in  means  of  communication  and  trans- 
portation takes  place,  facilitating  quick  and  speedy 
movement  of  cash  from  place  to  place,  the  banker  can 
safely  allow  his  reserve  to  fall  off  in  relation  to  deposits, 
knowing  that  additional  cash  may  be  got  promptly  in 


98  BANK  CREDIT 

order  to  meet  extraordinaiy  needs.  The  centraliza- 
tion of  reserves  and  the  creation  of  assured  facihties 
for  rediscount  enable  the  representative  banker  to 
conduct  liis  business  on  an  appreciably  lowered  reserve 
with  even  greater  assurance  of  an  unfaiUng  adequacy 
of  cash. 

Mr.  E.  D.  Hulbert  in  an  address  before  the  American 
Bankers'  Association,  September,  1918,  gave  point  to 
the  way  in  which  the  Federal  Reserve  System  favored 
the  certainty  of  meeting  all  demands  of  depositors 
easily  and  promptly,  although  that  system  has  ren- 
dered practicable  a  decided  reduction  in  the  ratio 
of  reserves  to  deposits: 

After  four  j^ears  of  trial  the  Federal  Reserve  Act  stands  as 
one  of  the  most  successful  and  beneficent  pieces  of  legislation 
ever  enacted  by  Congress.  What  it  has  done  for  the  country 
in  promoting  war  finance  cannot  be  computed.  ...  It  can 
safely  be  said  that  the  banking  business  of  the  countiy  has 
been  carried  on  during  the  past  four  years,  notwithstanding 
the  unprecedented  world  disturbance,  with  less  worry,  fore- 
boding and  fear  than  the  bankers  of  the  United  States  have 
experienced  in  any  other  four  years  of  their  lives.  .  .  . 

I  cannot  remember  any  four  years  since  I  have  been  a 
responsible  officer  of  a  bank  when  I  had  less  anxiety  as  to  the 
possibility  and  certainty  of  meeting  all  calls  from  depositors 
and  borrowers  as  I  have  during  the  last  four  years. 

It  has  been  demonstrated  that  financial  panics  can  be 
nipped  in  the  bud  and  normal  conditions  restored  with 
rapidity  under  the  operation  of  this  system.  There  is  no 
doubt  that  on  at  least  one  occasion  since  the  system  has  been 
in  operation  we  would  have  been  forced  to  issue  Clearing 
House  Certificates  under  the  old  regime,  and  we  all  know 
that  recovery  from  that  kind  of  shock  is  slow.    As  it  was  the 


SURPLUS  IN  RELATION  TO  LOANS,  ETC.    99 

banks  converted  over  $200,000,000  of  commercial  paper  into 
reserves  in  one  day  and  met  the  emergency.  No  one,  outside 
of  the  banks  in  the  central  reserve  cities,  knew  that  a  crisis 
had  occurred.  Most  of  this  loan  was  repaid  to  the  Federal 
Reserve  banks  inside  of  ten  days  and  as  a  shock  absorber  the 
efficiency  of  the  system  was  demonstrated  perfectly.^ 

Such  changes  in  the  economic  and  banking  organiza- 
tion as  have  been  mentioned  admit  of  a  reduction  in 
the  ratio  of  cash  to  deposits  without  impairing  the 
inmiediate  convertibility  of  deposits.  It  has  so  hap- 
pened in  the  evolution  of  our  economic  order  that 
certain  other  developments  have  occurred  that  permit 
a  reduction  in  the  ratio  of  surplus  to  creditor  liabilities 
without  an  impairment  of  the  chance  of  the  ultimate 
convertibility  of  those  liabilities. 

Any  institution  or  condition  that  reduces  business 
losses,  as  for  example,  the  growth  in  the  extent  and 
thoroughness  of  the  work  of  the  credit  departments 
of  business  concerns,  is  favorable  to  the  enduring  and 
unimpaired  value  of  bank  loans, — on  which  the  ulti- 
mate convertibility  of  creditor  obligations  of  banks 
largely  depends.  The  rise  and  development  of  the 
bank  credit  department  has  also  had  an  extremely 
salutary  effect  upon  the  uniform  soundness  of  bank 
assets. 

New  and  stricter  forms  of  bank  supervision  have 
done  much  to  eliminate  poor  investments  by  banks. 
A  more  equable  distribution  of  fire  losses  through  an 
enlarged    utilization    of    insurance    tends    to    reduce 

^  E.  D.  Hulbert,  Trust  Companies  and  the  Federal  Reserve  System, 
Trust  Companies,  October,  1918,  Vol.  XXVII,  No.  4,  p.  325. 


100  BANK  CREDIT 

business  failures,  supporting  and  stabilizing  bank 
assets  underljdng  the  ultimate  convertibility  of  cred- 
itor's claims.  Such  an  improvement  in  banking  facil- 
ities as  was  effected  by  the  establishment  of  the  Federal 
Reserve  System  is  calculated,  through  a  reduction  in 
commercial  losses  and  failures  due  to  money  stringen- 
cies and  crises,  to  make  the  value  of  loans  and  dis- 
counts, bonds  and  other  investments  less  subject  to 
fluctuation  and  depreciation.  Improvements  in  eco- 
nomic organization  and  underlying  conditions  during  a 
given  period  may  fully  offset  a  marked  reduction  in  the 
ratio  of  surplus  to  creditor  Uabihties,  leaving  the  like- 
lihood of  the  ultimate  convertibiUty  of  those  liabiUties 
unchanged  or  even  favorably  affected. 

The  striking  reduction  that  has  occurred  in  the 
ratio  of  surplus  to  deposits  and  other  creditor  habihties 
in  our  national  banking  system  since  its  inception  may 
not,  and  apparently  does  not,  represent  decUning 
prudence  on  the  part  of  our  bank  managements  in 
safeguarding  their  customers  against  loss  due  to  a 
shrinkage  of  bank  assets.  The  improvement  in  eco- 
nomic organization  and  in  fundamental  conditions,  if  we 
look  at  the  period  as  a  whole,  may  have  more  than 
counter-balanced  the  relative  dechne  in  surplus.  Our 
banks  could  not  now  withstand  such  large  losses  in 
relation  to  their  creditor  liabilities  and  still  pay  their 
creditors  in  full  as  they  could  have  withstood  forty  or 
fifty  years  ago,  but  the  creditors'  interests  are  con- 
ceivably just  as  safe,  even  safer,  today  because  losses 
corresponding  in  volume  to  those  of  the  sixties  and 
seventies  are  less  Ukely  to  occiu-. 

Perhaps  no  better  evidence  can  be  found  that  a 


SURPLUS  IN  RELATION  TO  LOANS,  ETC.       101 

declining  ratio  of  surplus  (and  the  other  protective 
items)  to  creditor  libilities  may  be  outweighed  by  im- 
provement in  the  conditions  underlying  bank  solvency 
than  the  decHning  percentage  of  loss  to  the  amount  of 
aU  deposits  in  our  national  banks  since  1880.  During 
the  33-year  period,  July  1,  1881,  to  June  30,  1914,  the 
average  annual  percentage  of  loss  to  the  amount  of 
all  deposits  in  national  banks  was  .628.  During  the 
3-year  period,  July  1,  1914,  to  June  30,  1917,  the  annual 
average  percentage  of  loss  was  only  .003  of  all  deposits 
in  national  banks.  ^  In  the  two  succeeding  years  the 
percentage  of  loss  dwindled  and  disappeared,  there 
being  only  one  national  bank  failure  in  1918  and  none 
in  1919,  a  circumstance  not  imtouched,  however,  by 
the  favorable  influence  of  flush  times. 

In  brief,  surplus  tends  to  vary  with  reserve  because 
forces  are  at  work  which  cause  the  ratios  of  reserve  to 
deposits  and  of  surplus  to  creditor  liabilities  to  vary  in 
the  same  direction,  if  not  to  the  same  extent.  Banking 
conservatism  tends  to  affect  each  ratio  in  the  same 
way.  Changes  in  the  economic  and  banking  organiza- 
tion that  admit  of  a  reduction  in  reserves  without  any 
reduction  in  the  chance  of  immediate  convertibility  of 
deposits  are  paralleled  by  other  changes  that  have  a 
similar  influence  and  effect  upon  surplus  in  relation  to 
creditor  obHgations.  What  has  been  said  should  not, 
however,  be  allowed  to  obscure  the  sharp  line  of  dis- 
tinction that  lies  between  the  nature  of  the  relation  of 
cash  to  deposits  and  that  of  surplus  to  creditor  liabili- 
ties. 

1  Report  of  the  Comptroller  of  the  Currency,  1917,  Vol.  I,  pp.  66, 
67 


102  BANK  CREDIT 

The  Relation  of  Cash  to  Deposits  vs.  the  Relation  of  Surplus 
to  Creditor  Liabilities 

The  dependence  of  immediate  convertibility  of 
depositors'  claims  upon  the  provision  of  a  cash  re- 
serve is  of  a  different  order  from  the  dependence  of  the 
ultimate  convertibility  of  creditors'  claims  upon  the 
provision  of  a  sm'plus  (or  even  capital).  The  depen- 
dence of  the  immediate  convertibihty  of  deposits 
upon  cash  is  both  absolute  and  relative,  whereas  the 
dependence  of  their  ultimate  convertibihty  upon 
surplus  (or  even  capital)  is  only  relative.  The  crea- 
tion of  a  surplus  simply  enhances  the  chance  of  the 
ultimate  convertibihty  of  deposits,  that  ultimate 
convertibility  having  been  already  reasonably  assured. 
The  existence  of  a  cash  reserve  on  the  contrary  is  essen- 
tial to  any  chance  whatsoever  of  immediate  converti- 
bility, while  an  increase  in  cash,  other  factors  remain- 
ing the  same,  simply  enhances  the  chance  of  immediate 
convertibihty,  once  a  reserve  has  been  established. 

The  banker  is  not  so  constantly  and  imperatively 
concerned  with  the  ratio  of  surplus  to  creditor  habiUties 
as  he  is  with  the  ratio  of  reserv' e  to  deposits.  Without 
the  provision  of  a  cash  reserve  a  bank  cannot  continue 
to  function,  except  during  a  period  of  suspension  of 
cash  payments.  But  a  bank  may  do  business  indefi- 
nitely without  a  surplus.  A  bank  may  even  be  insol- 
vent over  a  long  period  of  time  and  still  perform  all  the 
banking  functions  if  it  has  a  cash  reserv^e.^ 

^  For  the  case  of  a  Canadian  bank  that  was  probably  insolvent  for 
forty  years  before  its  failure,  see  Interviews  on  the  Banking  and  Cur- 
rency S^Jstems  of  Canada,  Publications  of  the  National  Monetary 
Commission,  1909,  p.  14. 


CHAPTER  VI 

Bankers'  Banks  and  Credit  Extension 
The  Nature  of  Bankers'  Banks 

What  the  ordinary  commercial  bank  does  for  its 
customers  a  bankers'  bank  does  for  banks.  An  indi- 
vidual bank  economizes,  mobilizes,  and  makes  flexible 
in  amount  the  funds  of  its  depositing  and  borrowing 
customers;  a  bankers'  bank  economizes,  mobilizes  and 
makes  flexible  in  amount  the  funds  of  commercial 
banks,  but  an  accurate  conception  and  comprehensive 
grasp  of  the  theory  of  bank  credit  can  not  be  had  with- 
out considering  the  way  in  which  these  institutions 
economize  or  dilute  cash  reserves. 

In  the  preceding  chapter  dealing  with  the  manu- 
facture of  bank  credit  by  commercial  banks,  as  if  they 
were  unaided  and  uninfluenced  by  bankers'  banks,  it 
was  convenient  and  legitimate  to  use  the  terms  cash 
and  reserve  synonymously.  In  the  present  chapter, 
however,  such  usage  is  not  permissible,  for  the  very 
good  reason  that  bankers'  banks  dilute  cash,  trans- 
forming or  rather  expanding  it,  into  a  larger  amount 
of  reserve.  In  this  chapter,  accordingly,  we  shall  have 
to  distinguish  sharply  between  cash  or  cash  reserve  on 
the  one  hand  and  reserve  on  the  other. 

103 


104  BANK  CREDIT 

Bankers'  Banks  Dilute  Cash 

The  way  in  which  bankers'  banks  dilute  cash  may  be 
made  clear  in  the  statement  that  the  deposit  liabiUties 
of  bankers'  banks  may  constitute  legal  reserve  for  com- 
mercial banks;  and  the  lower  the  cash-deposits  ratio  of 
the  bankers'  banks  (and  the  lower,  also,  their  ratio  of 
cash  to  notes),  the  greater  the  dilution. 

Federal  Reserve  Banks  Illustrative 

The  Federal  Reserve  Act,  which  became  law  De- 
cember 23,  1913,  provided  for  the  estabhshment  of  a 
group  of  regional  bankers'  banks,  and  since  November 
16,  1914,  twelve  such  institutions  have  been  in  opera- 
tion. The  Federal  Reserve  banks,  located  in  Boston, 
New  York,  Philadelphia,  Cleveland,  Richmond,  At- 
lanta, Chicago,  St.  Louis,  MinneapoHs,  Dallas,  Kansas 
City  and  San  Francisco,  are  new  creations,  superim- 
posed upon  the  pre\dously  existing  system  of  national 
and  state  banks  and  trust  companies.  The  old  classi- 
fication of  national  banks  as  Central  Reserve  City 
banks  (all  national  banks  in  New  York,  Chicago  and 
St.  Louis),  Reserve  City  banks  (all  national  banks  in 
about  50  cities  hke  Columbus,  Ohio,  and  Pittsburg, 
Pa.),  and  Country  banks  (all  other  national  banks) 
is  still  retained  and  an  effort  may  be  required  to  dis- 
tinguish these  various  classes  of  national  banks  from 
the  recently  established  Federal  Reserve  or  regional 
banks. 

All  national  banks  were  required  as  the  price  of  re- 
taining their  national  charters  to  become  members  of 
the  Federal  Reserve  system,  by  which  is  meant  that 


BANKERS'  BANKS  AND  CREDIT  EXTENSION    105 

they  were  required  to  purchase  stock,  equal  to  3  per 
cent  of  their  capital  and  surplus  in  each  case  and  to 
subscribe  for  an  additional  3  per  cent,  in  the  Federal 
Reserve  bank  of  the  district,  and  to  keep  a  part  of  their 
reserves  on  deposit  with  the  regional  institutions.  State 
banks  and  trust  companies  have  been  allowed  and  en- 
couraged to  enter  as  members  on  substantially  the 
same  terms  as  national  banks.  Most  state  banks  and 
trust  companies  of  importance  are  members  of  the 
system. 

Owned  by  member  banks,  the  regional  institutions  are 
controlled  mainly  by  (a)  the  Federal  Reserve  Board  of 
seven  members,  appointees  of  the  President  of  the 
United  States,  and  (b)  directorates,  each  consisting 
of  nine  men,  six  of  whom  are  chosen  by  member  banks 
of  the  district  concerned  and  three  by  the  Federal  Re- 
serve Board. 

The  principal  functions  of  the  Federal  Reserve 
banks  are  to  receive  deposits  from  members  and  from 
the  Federal  government,  to  issue  notes  and  to  make 
loans.  The  regional  banks  render  service  to  members 
that  is  analogous  to  that  rendered  by  the  members  to 
their  own  customers. 

A  member  bank  borrowing  from  a  Federal  Reserve 
bank  would  conmionly  take  the  proceeds  of  the  loan 
in  either  Federal  Reserve  notes  or  as  a  deposit  credit 
on  the  books  of  the  Federal  Reserve  bank.  Against 
Federal  Reserve  notes  the  issuing  bank  is  expected  to 
keep  a  minimum  reserve  of  40  per  cent  in  gold;  against 
deposits,  a  minimum  reserve  of  35  per  cent  in  gold  or 
lawful  money. 

Our  national  and  state  banks,  which  own  and  largely 


106  BANK  CREDIT 

control  the  Federal  Reserve  banks,  are  compelled  to 
keep  their  requked  reserves  on  deposit  with  the 
Federal  Reserve  banks.  The  cash  reserves  of  the 
commercial  banks,  lodged  with  the  Federal  Reserve 
banks,  become  the  basis  of  multiplied  loans  to  the 
commercial  or  member  banks  and  of  multiphed  de- 
posits owed  to  those  same  members.  But  the  deposits 
of  the  member  banks  on  the  books  of  the  Federal  Re- 
serve banks  are  legal  reserve  for  the  member  banks. 
When  cash  was  transferred  from  the  vaults  of  member 
banks  to  the  Federal  Reserve  vaults,  it  ceased  to  be 
reserve  for  the  member  banks,  and  became  reserve  for 
the  Federal  Reserve  banks,  and  the  deposit  Uahilities 
of  the  Federal  Reserve  banks  assumed  the  role  of  re- 
serve for  the  member  institutions.  Such  deposit 
HabiMties  are  called  reserve  deposits.  Commercial 
banks  expand  the  credit  supporting  power  of  cash 
lying  in  their  vaults;  and  bankers'  banks,  when  the 
cash  is  transferred  to  their  vaults,  magnify  this  ex- 
pansive power. 

This  magnified  expansive  power  and  the  process  of 
cash  dilution  to  which  it  is  traceable,  will  be  seen  in  a 
clearer  hght  if  we  refer  directly  to  the  consoHdated  and 
condensed  balance  sheet  of  the  twelve  Federal  Reserve 
or  regional  banks,  which  we  may  properly  regard  as 
one  great  bank  of  branches.^  The  assets  and  liabihties 
in  round  numbers  are  as  follows: 

1  We  are  justified  in  looking  upon  the  twelve  Federal  Reserve 
banks  as  a  unit  in  this  connection  because  member  banks  are  re- 
quired to  maintain  all  of  their  required  reserv^es  on  deposit  wath  the 
regional  banks,  /nira-district  shifting  of  reserves  involves  only  a 
transfer  of  credits  on  the  books  of  the  regional  bank  at  the  head  of 


BANKERS'  BANKS  AND  CREDIT  EXTENSION    107 

Assets  Liabilities 

Loans $3  billions    To  Shareholders.. .  $   .17  billions 

Cash 2       "         Notes 3 

Other  Assets 1       **         Deposits 2  " 

Other  Liabilities.  .      .83      " 


$6  billions  $6        billions 

If  now  a  billion  dollars  were  lodged  by  the  member 
banks  in  the  vaults  of  the  Federal  Reserve  banks,  the 
cash  of  the  regional  institutions  would  be  raised  from  2 
to  3  billions  and  the  deposits  likewise  from  2  billions  to 
3  billions,  the  ratio  of  cash  to  demand  liabihties  rising 
for  the  time  from  40  per  cent — 2  to  5— to  50  per  cent 
— 3  to  6.  That  is,  the  Federal  Reserve  banks  would 
have  an  idle  reserve  of  600  millions,  if  the  40  per  cent 
reserve  ratio  was  still  adhered  to,  even  after  the  mem- 
ber banks  had  been  credited  1  billion, — an  amount 
that  would  continue  to  be  the  actual  foundation  of 
deposits  of  ten  billions  on  the  books  of  member  banks. 

If  the  unused  reserve  was  employed  as  support  for 
additional  issues  of  Federal  Reserve  notes,  an  expan- 
sion of  1.5  bilHons  (2^  X  $600,000,000)  would  take 
up  the  excess  in  the  reserves,  and  the  transfer  of  the 
bilhon  in  cash  from  the  commercial  to  the  bankers' 
banks  would  result  in  a  relatively  slight  expansion  of 
loans  and  deposits  of  the  commercial  banks,  through 
which  the  Federal  Reserve  notes  tend  to  pass  into  cir- 
culation, those  notes,  fortunately,  not  being  eligible 
for  general  use  as  legal  reserve. 

Nevertheless,  the  fact  that  Federal  Reserve  notes 

the  district;  in(er-district  shifting  of  reserves,  a  transfer  of  credits 
from  the  books  of  one  regional  bank  to  the  books  of  another. 


108  BANK  CREDIT 

cannot  be  used  to  satisfy  the  legal  resen^e  requirements 
of  national  and  some  state  banks,  notably  all  New 
York  State  banks,  is  partially  offset  by  another  cir- 
cumstance which  has  often  been  overlooked.  National 
banks,  in  accordance  with  pro^dsions  of  the  Federal 
Resers'e  Act,  keep  their  legally  required  reserves  with  the 
Federal  Reserve  banks.  Against  demand  deposits 
Country  banks  are  required  there  to  maintain  7  per 
cent,  Reser^^e  City  banks,  10  per  cent  and  Central  Re- 
serv'e  City  banks,  13  per  cent;  all  three  classes,  3  per 
cent  against  tune  deposits.  However,  to  the  stipulated 
legally  required  reserv^es  must  be  added  whatever 
amount  banking  prudence  and  necessity  compel  mem- 
ber banks  to  keep  actually  on  hand  to  meet  day-to-day 
demands  for  cash.  That  such  funds  are  called  till 
money  does  not  alter  their  essential  character,  and 
inasmuch  as  Federal  Reserv^e  notes  are  eUgible  for 
use  and  are  very  extensively  used  by  member  banks  as 
till  money,  sight  should  not  be  lost  of  the  fact  that  they 
also,  to  the  extent  that  they  are  used  as  till  money, 
serve  to  support  manifold  loans  and  deposits  of  mem- 
ber banks.  Federal  Reserve  notes,  therefore,  have 
a  multiphcative  power  of  credit  support,  although 
clearly  not  so  great  as  that  of  reserve  deposits.  This 
pecuhar,  partial  character  of  the  credit  supporting 
power  of  Federal  Reser\'e  notes  is  indicated  in  dia- 
gram 4. 

If  surplus  reserves  of  $600,000,000  in  the  vaults  of  the 
regional  banks  were  there  utihzed  wholly  as  a  basis  of 
new  loans  and  deposits,  an  expansion  of  only  1.7 -|- 
bilHons  would  be  possible,  a  35  per  cent  reser\'e  being 
required  against  deposits,  but  the  case  would  be  dif- 


BANKERS'  BANKS  AND  CREDIT  EXTENSION      109 


Loans  ^^^THSREPoise 
Depos/T^ 

''^  M£MB£f^  3a/^KS, 
20  &/I.CWNS. 

1 

^SE-JSV'E 
D£f>OSfTS. 

z 

B/i.i./ONS. 

Fede/sal 

12ES£IS\/e 

Notes. 
SqiL'-ioN'S. 

Loans  o£ 
£anhs, 

3  B/i-L^ONS. 

Goi.a^^°LAi>/AU^  Money, 
2  att.i./oA/s. 

Diagram  4 


Government  deposits,  $75,587,000,  and  "other  deposits,  includ- 
ing foreign  Government  credits,"  $95,306,000  (February  20,  1920) 
are  not  represented  in  diagram  4.  These  items  combined  are  of 
relatively  slight  importance,  being  less  than  10  per  cent  of  "due 
to  members-reserve  account,"  $1,828,891,000  on  the  date  mentioned. 
Simplicity  and  clarity  also  dictate  the  omission  of  Federal  Reserve 
bank  notes  from  the  diagram.  These  notes,  issued  by  the  Federal 
Reserve  banks,  are  of  the  same  tenor  as  national  bank  notes;  the 
amount  outstanding,  February  20,  1920,  being  $240,858,000  as 
against  $2,977,124,000  of  Federal  Reserve  notes. 

Loans  and  deposits  of  member  banks  arc  represented  in  the  dia- 
gram as  equal  although,  chiefly  on  account  of  the  swollen  Federal 
Reserve  note  issues,  there  has  been  a  strong  tendency  for  loans  to 
outstrip  deposits. 


110  BANK  CREDIT 

ferent  from  that  involving  an  expansion  of  notes  be- 
cause the  new  deposits,  constituting  legal  reserve  for 
member  banks,  would  enable  those  member  banks 
taken  in  the  aggregate  to  expand  their  loans  and  de- 
posits by  approximately  10  times  1.7  billions.  That  is 
to  say,  if  the  maximum  credit  expansion  were  attained, 
on  the  basis  of  deposits,  to  the  entire  exclusion  of  notes, 
the  biUion  dollars  transferred  from  the  member  banks 
would  be  made  to  support  not  only  10  billions  in  loans 
antecedently  supported,  but  an  additional  amount  of 
17  bilHons.  Under  those  conditions  a  dollar  in  the 
vaults  of  the  Federal  Reserve  banks  would  have  ap- 
proximately two  and  a  half  times  as  much  credit  sup- 
porting power  as  a  dollar  in  the  vaults  of  the  member 
banks  would  have  if  the  bankers'  banks  were  non- 
existent. 

In  brief,  the  degree  or  measure  of  cash  dilution  de- 
pends upon  whether  reef  in  the  reserve  sail  is  utiUzed 
in  note-  or  deposit-expansion.  At  the  end  of  five  years 
of  the  Federal  Reserve  system,  the  notes  and  deposits 
stand  in  the  ratio  ^  of  3  to  2  approximately,  as  the 
simphfied  balance  sheet  indicates  and  as  diagram  4 
shows. 

As  diagram  4  indicates,  the  two  billions  of  cash  held 
by  the  Federal  Reserve  banks  indirectly  support 
twenty  biUions  of  deposits  on  the  books  of  member 
banks  and  three  biUions  of  Federal  Reserve  notes  in 
addition. 

1  Whether  member  banks  take  the  proceeds  of  their  loans  or  re- 
discomits  at  the  Federal  Reserv^e  bank  in  notes  or  deposits  depends 
upon  whether  the  demands  of  the  customers  of  the  member  banks 
are  for  notes  or  deposits. 


BANKERS'  BANKS  AND  CREDIT  EXTENSION      111 

Would  member  banks  have  the  same  volume  of 
loans  and  deposits,  20  billions  in  round  numbers,  if  the 
cash  of  national  and  state  banks  had  not  been  gathered 
together  in  the  vaults  of  the  regional  or  bankers'  banks 
where  now  it  serves  to  support  both  notes  and  de- 
posits? If  the  regional  banks  had  not  been  established, 
a  billion  dollars  of  European  gold  coming,  as  it  did, 
into  our  banks,  would  have  set  loan — and  deposit- 
expansion  in  motion,  prices  would  have  risen,  and  the 
accompanying  need  and  demand  for  additional  hand 
to  hand  money  would  have  drawn  lawful  money,  in 
the  absence  of  elastic  note  issues,  from  the  banks  into 
circulation.  Such  a  withdrawal  of  lawful  money  from 
bank  reser\^es  to  the  channels  of  circulation  would 
have  checked  and  restricted  expansion  of  credits  on 
the  books  of  the  lending  national  and  state  banks. 
The  centralization  of  reserves  and  the  issue  of  elastic 
notes,  have  prevented  the  withdrawal  of  lawful  money 
from  commercial  banks  during  a  period  of  great  loan 
and  deposit  expansion. 

In  response  to  customers'  demands  for  additional 
hand  to  hand  money,  demands  arising  out  of  rising 
prices  caused  chiefly  by  previous  loan  and  deposit  ex- 
pansion, member  banks  have  obtained  through  bor- 
rowing, rediscounting,  or  otherwise  and  largely  paid 
out  over  their  own  counters  Federal  Reserve  notes 
to  the  amount  of  three  billion  dollars.  Federal  Reserve 
notes  have  thus  through  a  monetary  division  of  labor 
made  it  possible  for  lawful  money  to  be  utilized  in 
its  most  efficient  and  inflationistic  capacity.  The 
Federal  Reserve  notes  relieve  lawful  money  of  its  de- 
clining function  as  a  medium  of  exchange,  allowing  it 


112  BANK  CREDIT 

to  render  the  higher  service  of  bank  reserves,  in  banks 
where  reserv^es  have  a  maximiun  of  credit  supporting 
power.  TMierever  Federal  Reserve  notes  release  lawful 
money  in  circulation  for  the  higher  work  of  bank  re- 
ser\''es,  wherever  they  prevent  a  depletion  or  loss  of 
bank  reserves  during  a  period  of  rising  prices  or  ex- 
panding business,  and  wherever  they  serve  as  till  money 
in  member  banks  and  as  resen^es  in  non-member  banks, 
— there  they,  too,  carry  a  multipHcative  power  of 
credit  expansion  and  support. 

Maximum  bank  credit  expansion  imder  the  influence 
of  the  Federal  Reserve  banks,  then,  would  take  place, 
ceteris  paribus,  if  note  issues  were  kept  at  a  minimum 
while  deposits  of  Federal  Resen-^e  banks  were  extended 
to  a  maximum,  and  a  minimum  of  expansion  would 
take  place  if  note  issues  reached  a  maximiun  and  de- 
posits were  kept  at  a  minimum.  The  spread  of 
deposit  banking  and  the  more  and  more  widespread 
use  of  checks  are  circumstances,  therefore,  that  work 
very  powerfully  in  the  direction  of  continued  infla- 
tion. 

Future  Credit  Expansion  under  the  Federal  Reserve 

System 

Although  surplus  reserves  in  the  Federal  Reserve 
system  have  been  reduced  to  comparatively  small 
proportions  it  would  be  a  mistake  to  beUeve  that  very 
substantial  fm'ther  expansion  of  loans  and  deposits 
within  the  system,  including  the  member  banks,  is  cut 
off  as  a  possibihty,  even  though  no  change  is  made  in 
reserve  requirements.  It  must  not  be  lost  sight  of 
that  a  billion  and  a  half  dollars  of  lawful  money — 


BANKERS'  BANKS  AND  CREDIT  EXTENSION      113 

chiefly  gold  certificates,  silver  certificates,  and  green- 
backs— still  circulate  outside  the  vaults  of  the  Federal 
Reserve  banks  as  potential  reserve.  Through  a  sub- 
stitution of  Federal  Reserve  notes  for  lawful  money, 
the  latter  may  be  obtained  by  the  Federal  Reserv^e 
banks  and  may  become  the  legal  reserve  foundation  of 
a  manifold  credit  expansion  in  the  years  that  are 
ahead. 

Not  only  so;  the  Federal  Reserve  Board,  clothed 
with  controlling  power  over  the  classification  of  re- 
serve cities,  may  by  a  simple  ruling,  give  freer  lending 
rein  to  member  banks.  Such  action,  already  agitated, 
would  require  no  legislative  enactment,  and  we  may  in 
the  future  witness  a  further  dilution  of  cash  through  a 
reclassification  of  cities.  Such  a  reclassification  or 
demotion  of  cities  now  classed  as  Reserve  cities  as  well 
as  those  classified  as  Central  Reserve  cities  would 
be  the  equivalent  of  an  outright  reduction  in  the 
reserve  percentage  required  to  be  maintained  with  the 
Federal  Reserve  banks  by  their  demoted  members. 
If  Buffalo,  to  take  a  single  example,  were  to  lose  its 
designation  as  a  Reserve  city,  Buffalo  banks  would  be 
required  to  keep  a  reserve  against  demand  deposits 
not  of  10  per  cent  but  of  only  7  per  cent. 

The  power  of  the  Federal  Reserve  Board  to  permit  a 
reduction  of  the  note  reserve  below  40  per  cent,  with 
a  graduated  tax  on  the  deficiency,  and  the  power  to 
suspend  any  reserve  requirement  for  "a  period  not 
exceeding  thirty  days,  and  from  time  to  time  to  renew 
such  suspension  for  periods  not  exceeding  fifteen  days," 
— these  powers  are  designed  to  meet  extreme  emergen- 
cies and  require  no  comment. 


114  BANK  CREDIT 

The  Rediscount  Rate  as  a  Factor  in  Credit  Extension 

Within  the  Umits  indicated  the  extension  of  the  loans 
and  resulting  reserve  deposits  or  Federal  Reserve  notes 
of  the  Federal  Reserve  system  and  hence  the  future 
extension  of  loans  and  deposits  of  our  commercial 
banks  will  be  determined  in  no  small  measure  by  the 
rates  of  rediscount  enforced  by  the  Federal  Reserve 
banks  under  the  guiding  influence  of  the  Federal  Re- 
serve Board.  But  this  statement  calls  for  explanation 
and  amplification. 

We  have  already  observed  (Chapter  IV)  that  the 
banker  exercises  a  regulative  or  corrective  power  over 
the  ratio  of  reserves  to  deposits  by  increasing  or  cur- 
tailing loans.  Where,  however,  he  has  access  to  a 
bankers'  bank,  notably  one  of  the  Federal  Reserve 
banks,  he  may  regulate  and  control  his  reserv^e-de- 
posits  ratio  by  borrowing  or  rediscounting.  When- 
ever shortage  of  reserve  exists  or  threatens,  the  banker 
may  tap  the  lending  power  of  the  bankers'  bank  and 
there,  through  rediscounting  or  direct  borrowing  on 
the  secured  obUgation  of  his  own  bank,  obtain  an  ad- 
dition to  his  reserves  in  the  form  of  either  a  deposit 
credit  on  the  books  of  the  bankers'  bank  or  of 
''money"  that  may  be  paid  out  to  meet  demands  for 
cash  at  the  paying  teller's  window. 

Rediscounting  and  direct  borrowing  on  secured 
obligations  at  the  Federal  Reserve  banks  have  be- 
come very  common  as  a  means  of  replenishing  mem- 
ber bank  reserves,  and  the  ease  with  which  member 
banks  have  been  able  to  borrow  from  the  Federal 
Reserve  banks  has   served   clearly  to   mark  off   the 


BANKERS'  BANKS  AND  CREDIT  EXTENSION      115 

period  since  1914  as  a  new  era  in  bank  opera- 
tion. 

The  following  table  gives  an  itemized  account  of 
the  advances  made  bj^  the  twelve  regional  banks  as 
of  January  23,  1920:  ^ 

Bills    discounted   secured    by    Government   war 

obligations $1,386,348,000 

All  other  bills  discounted 767,110,000 

Bills  bought  in  open  market 575,789,000 

United  States  Government  bonds 27,036,000 

United  States  Victory  notes 64,000 

United  States  certificates  of  indebtedness 276,765 

It  is  well  to  keep  in  mind  that  reserve  acquisitions 
obtained  through  rediscounting  or  borrowing  con- 
stitute a  more  ample  source  of  credit  extension  than 
do  reser\^e  accretions  obtained  from  depositors:  the 
borrowing  bank  keeps  no  reserve  against  the  obliga- 
tion to  a  lending  institution,  whereas,  it  must  keep  or 
withhold  a  reserve  against  an  obligation  arising  out  of 
the  deposit  of  funds  by  a  customer.  How  much  a  bor- 
rowing bank  can  lend  on  the  basis  of  a  reserve  acquisi- 
tion obtained  through  borrowing  is  ascertainable  by 

the  application  of  the  formula,  a;=  — r,  already 

developed,  page  54.  The  application  of  this  formula 
(in  which  x  stands  for  the  amount  that  an  individual 
bank  can  lend  on  the  basis  of  a  reserve  acquisition  or 
surplus  reserve;  c,  for  the  surplus  reserve;  k,  for  the 
derivative  deposit-loan  ratio;  and  r,  for  the  reserve- 
deposits  ratio)  indicates  that  a  typical  bank  can  increase 
its  loans  by  approximately  $1.22  for  every  dollar  bor- 

1  Federal  Reserve  Bulletin,  Vol.  6,  No.  2,  February,  1920,  p.  196. 


116  BANK  CREDIT 

rowed.  A  rate  of  rediscount,  therefore,  that  equals  or 
exceeds  the  rate  of  discount  tends  strongly  to  check 
borrowing  by  the  commercial  banks.  This  is  true, 
even  if  the  commercial  banks  are  borrowing  freely  and 
simultaneously.  Under  those  circumstances  an  in- 
di\ddual  member  bank  would  be  able  to  add  approxi- 
mately ten  times  as  much  to  loans  as  the  amount  bor- 
rowed at  the  Federal  Reserve  bank,  but  most  of  the 
additional  lending  power  would  be  traceable  to  the 
loan  expansion  of  other  member  banks,  and  only  the 
amount  arrived  at  by  the  application  of  the  formula 
would  be  due  to  funds  borrowed  from  the  bankers' 
bank. 

If  the  Mad  River  National  Bank  of  Springfield, 
Ohio,  refrains  from  rediscounting  while  all  other  banks 
are  so  doing,  its  primary  deposits  will  tend  to  rise  in 
response  to  the  fact  that  its  customers  receive  a  greater 
volume  of  checks  than  pre\dously,  and  in  trnn,  place 
those  checks  on  deposit,  thereby  increasing  the  lend- 
ing power  of  their  bank,  the  Mad  River  National.  If 
that  bank  borrowed  $100,000  en  bloc  from  the  Federal 
Reserv^e  Bank  of  Cleveland  the  additional  or  surplus 
reserve  thereby  obtained  would  enable  the  Springfield 
institution  to  add  approximately  $122,000  to  its  loans, 
if  its  cash-deposits  ratio  were  10  per  cent  and  its  cus- 
tomers on  the  average  left  20  per  cent  of  their  loans 
on  deposit.  Of  the  $122,000  loaned,  approximately 
$97,600  (80  per  cent)  would  be  drawn  against  by  check, 
the  checks  being  sent  to  creditors  of  the  borrowers. 
The  recipients  of  the  checks,  placing  them  on  deposit 
at  their  own  banks,  would  give  those  banks  a  claim  on 
the  reserve  of  the  Mad  River  National.    In  time  the 


BANKERS'  BANKS  AND  CREDIT  EXTENSION     117 

borrowed  funds  would  become  distributed  widely 
through  the  banking  system  as  the  residualized  founda- 
tion of  manifold  loans  and  deposits.  In  that  process, 
however,  the  Mad  River  National  Bank  would  retain 
only  a  small  proportion,  $100,000— $97,600  or  $2,400, 
as  reserve  against  derivative  deposits  of  approximately 
$24,000,  the  last  amount  being  20  per  cent  of  the 
$122,000  extended  in  loans. 

It  is  clear  that  the  profitableness  of  rediscounting 
depends  upon  the  difference  between  the  rate  of  dis- 
count that  the  borrower  pays  his  bank  and  the  rate  of 
rediscount  that  his  bank  pays  the  bankers'  bank. 
As  this  page  is  written,  the  rate  of  rediscount  for  com- 
mercial paper  at  the  Federal  Reserve  Bank  of  New 
York  is  being  raised  from  6  to  7  per  cent.  The  resulting 
tendency  will  be  (1)  to  make  rediscounting  less  profit- 
able to  member  banks,  (2)  to  cause  the  rates  paid  by 
borrowers  to  rise,  and  (3)  to  curtail  loans  and  therefore 
deposits  of  the  borrowing  banks.  We  may  add  that 
since  deposits  are  purchasing  power,  a  rise  in  the  rate 
of  rediscount,  which  tends  to  curtail  loans  and  deposits, 
tends  to  depress  general  prices,  to  reduce  profits  and 
to  check  business  expansion.  Conversely,  a  reduction 
in  the  rate  of  rediscount  tends  to  increase  loans  and 
deposits  and  to  cause  prices  to  rise.  Rising  prices 
result  in  rising  profits,  and  greater  profits  are  an  incen- 
tive to  extend  plant,  equipment,  and  scale  of  opera- 
tions. If  labor  and  capital  goods  were  not  fully  em- 
ployed at  the  time,  a  reduction  in  the  rate  of  rediscount 
might  set  latent  productive  forces  free  resulting  in  an 
increase  in  product  and  in  the  volume  of  trade.  If 
labor  and  capital  goods  were  fully  employed,  the  ex- 


118  BA>nC  CREDIT 

pansion  of  loans  and  deposits  resulting  from  a  reduction 
in  the  rediscount  rate  would  tend  to  be  absorbed  in 
higher  prices  for  an  unchanged  volume  of  exchangeable 
goods.  A  change  in  the  rate  of  rediscount  tends  to 
be  reflected  in  changes  in  the  price  level  and,  generally, 
in  the  physical  volume  of  trade,  a  rise  in  the  rediscount 
rate  curtailing  trade  and  industry  and  a  reduction  hav- 
ing the  opposite  effect.^ 

But  the  controlling  influence  of  the  rate  of  redis- 
count of  the  Federal  Reserve  banks  is  founded  on  the 
close  relation  of  that  rate  to  the  rate  of  discount  of  the 
commercial  or  member  banks. 

If  the  traditional  theory  of  bank  credit  were  valid, 
the  rate  of  rediscount  would  have  to  be  raised  to  a  point 
several  times  as  high  as  the  rate  current  in  the  market 
before  rediscounting  would  become  unprofitable.  If 
the  traditional  theory  were  valid,  high  rediscount 
rates — up  to  40  or  50  per  cent — would  have  only  a  moral 
influence  in  curtailing  loans  and  deposits.  If  we  ac- 
cept the  premises  of  the  old  theory  of  bank  credit  the 
conclusion  stated  is  unavoidable.  Thus  Henry  HazHtt 
of  the  Mechanics  and  Metals  National  Bank  of  New 
York,  writing  in  Trust  Companies  says: 

1  To  the  extent  that  a  rise  in  the  rediscount  rate  and  the  conse- 
quent reduction  in  bank  loans  and  deposits  might  curtail  production 
and,  after  a  lapse  of  time,  the  physical  volume  of  trade,  the  tendency 
toward  a  reduction  in  general  prices  would  be  retarded.  If,  on  the 
contrary,  a  rise  in  the  rate  of  rediscount  and  consequently  in  the 
rate  of  interest  or  discount,  impelled  holders  of  goods  and  securities 
to  throw  their  holdings  on  the  market  because  of  the  increased  cost 
of  reqmsite  borrowed  funds,  the  accelerated  movement  of  securities, 
merchandise,  and  wares,  that  is,  the  increased  physical  volume  of 
trade,  would  accentuate, /or  the  time  being,  the  falling  price  level. 


BANKERS'  BANKS  AND  CREDIT  EXTENSION     119 

"A  high  discount  rate  for  the  Reserve  banks  is  mainly 
important  for  its  moral  effect.  It  does  not  make  it 
unprofitable  for  the  banks  to  rediscount.  A  bank  in 
New  York  City  may  rediscount  S  13,000  of  commercial 
bills  and  pay  6  per  cent  for  so  doing,  but  it  thereby 
obtains  a  credit  of  approximately  $13,000  from  the 
Reserve  bank,  on  which  it  is  able  to  lend  $100,000  at 
6  per  cent  or  more  to  individuals.  The  rediscount  rate 
would  have  to  be  raised  to  more  than  40  per  cent  to 
make  such  a  transaction  actually  unprofitable,  and  of 
course  such  a  rate  is  ridiculous.  If  the  moral  effect  of  a 
reasonably  high  rediscount  rate  is  not  great  enough  to 
stop  the  expansion  of  credit,  then  the  reserve  banks 
should  use  freely  their  powers  of  rationing  and  alloca- 
tion."! 

Happily,  the  time-worn  theory  of  bank  credit,  upon 
which  rests  the  contention  embodied  in  the  quotation 
given  above,  is  erroneous  and  the  rediscount  rate  of 
the  Federal  Reserve  banks  is  available  and  effective 
as  a  regulator  of  bank  loans  and  deposits,  of  business 
expansion  and  contraction  and,  within  limits,  of  general 
prices. 

Commercial  Banks  as  Bankers'  Banks 

Having  perceived  the  way  in  which  bankers'  banks 
dilute  cash,  and  the  way  in  which  the  operation  of  our 
regional  institutions  affect  the  loans  and  deposits  of 
member  banks,  we  need  only  to  be  reminded  that  many 
of  our  national  and  state  banks  served  as  bankers '  banks 

1  Henry  Hazlitt,  Why  the  United  Slates  Must  Protect  Its  Gold 
Standard,  Trust  Companies,  Vol.  XXX,  No.  2,  February,  1920, 
p.  154. 


120  BANK  CREDIT 

as  well  as  commercial  lending  agencies  before  the  es- 
tablishment of  the  Federal  Reserve  system  in  1914  and 
that  many  still  so  serve,  but  on  a  relatively  restricted 
scale.  The  outstanding  circumstance  that  distin- 
guishes the  work  of  the  Federal  Reserve  banks  from 
that  of  our  national  and  state  institutions  serving  in 
the  capacity  of  bankers'  banks  is  that  under  the 
existing  regional  system  members  are  legally  compelled 
to  keep  all  of  their  required  reserves  as  deposits  with 
the  regional  banks,  whereas  before  1914  it  was  not 
mandatory  but  merely  permissible  to  keep  a  fraction 
of  the  reqmred  reserves  on  deposit  with  other  institu- 
tions. The  Federal  Reserve  Act  has  not  only  lowered 
the  reserve  requirements  of  national  banks;  it  has  in- 
creased the  quantity  of  our  reserves  at  the  expense  of 
quahty.  The  pronounced  dilution  or  watering  of  re- 
serves results  from  an  extreme  extension  of  the  prin- 
ciple of  bankers'  banking  under  the  Federal  Reserve 
system,  wherein  all  deposit  habilities  of  the  regional 
institutions  serve — and  those  liabilities  alone  may  serve — 
as  the  legally  required  reserves  of  all  national  and  many 
state  banks.  The  compulsory  concentration  of  reserves 
under  the  operation  of  the  Federal  Reserve  Act  was  a 
step  requisite  to  an  ideal  banking  system,  but  fruitful 
of  inflation — an  inflation  that  might  have  been  held  in 
check  by  a  regulation  of  reserve  requirements.^ 

1  If  there  is  any  weakness  in  the  Federal  Reserve  system  in  this 
connection,  it  is  to  be  found  in  the  too  great  reduction  of  reserve 
requirements  and  not  in  the  much  needed  centraHzation  of  reserves. 

For  an  account  of  the  weaknesses  of  our  banking  system  prior  to 
1914  see  the  writer's  Readings  in  Money  and  Banking  (Macmillan), 
1916,  Chapter  XXX. 


PART  II 
QUALITATIVE  ASPECTS  OF  BANK  CREDIT 


CHAPTER  VII 

Recent  Changes  in  Our  Bank  Credit 
Arrangements 

The  principal  changes  in  our  bank  credit  arrange- 
ments since  the  Civil  War  and  more  especially  during 
the  last  twenty-five  years,  relate  to  the  form  of  the 
bank  borrower's  obligation,  the  development  of  the 
note  brokerage  business,  the  rise  of  the  bank  credit 
department,  the  rise  and  expansion  of  the  new  business 
department,  and  the  establishment  and  operation  of 
the  Federal  Reserve  system.  An  account  of  some 
of  the  more  important  aspects  of  these  changes,  fol- 
lowing the  order  just  given,  may  well  serve  as  an  intro- 
duction to  a  somewhat  detailed  analysis  of  the  factors 
underlying  and  affecting  the  quality  or  soundness  of 
bank  advances. 

Evolution  in  the  Form  of  the  Borrower's  Obligation 

The  form  of  the  instrument  of  our  bank  loans  has 
undergone  very  appreciable  change  during  the  last 
half  century.  That  change,  however,  has  been  far 
from  uniform  in  time  and  place  and  defies  treatment 
that  is  at  once  concise  and  definitive.  An  exhaustive 
discussion  of  this  aspect  of  our  subject,  which  would 
be  in  itself  a  fit  topic  for  a  volume,  must  gi\^e  way  to 
an  account  of  only  the  main  modifications  and  devel- 
opments in  the  form  of  our  banking  paper. 

123 


124  BANK  CREDIT 

One  of  the  outstanding  features  of  our  banking 
practice  during  the  last  half  century  or  more  is  the 
change  of  emphasis  placed  on  the  personal  standing  of 
the  borrower.  Fifty  or  sixty  years  ago  single  name 
paper  was  scarcely  known.  Banks  refused  to  make 
advances  on  the  security  afforded  by  the  borrower's 
signature  alone  and  insisted  upon  one  or  more  endors- 
ers. The  banker  who  loaned  on  single  name  paper 
mthout  additional  security  was  regarded  as  the  re- 
verse of  conservative,  if  not  positively  reckless.  In 
the  country  districts,  where  borrowed  money  was  in- 
vested largely  in  fixed  property  and  where  the  money 
was  loaned  on  endorsed  accommodation  paper  more 
extensively  than  in  the  large  centers,  borrowers  some- 
times became  so  involved  as  endorsers  for  one  another 
that  there  resulted  a  situation,  which,  when  pressure 
was  brought  to  bear  for  payment,  resembled  a  row  of 
bricks  standing  on  end  so  that  if  one  were  knocked  down, 
it  would  fall  on  another  until  all  were  bowled  over.^ 

The  use  of  endorsed  paper  led  to  endorsing  for  ac- 
commodation. When  a  borrower  had  no  more  cus- 
tomers' notes  he  applied  to  one  of  his  friends  to  ex- 
change his  note  for  his  own  and  had  it  discounted  at 
his  bank.  The  friend  did  the  same  thing  in  his  (a 
different)  bank.  Whenever  one  of  these  accommoda- 
tion endorsers  got  into  trouble  the  other  was  affected 
adversely,  and  hea\y  losses  occurred  yearly  by  what 
was  called  two-name  paper. ^    Endorsed  accommodation 

1  James  B.  Forgan,  Evolution  in  Banking  Thought  during  the 
Past  Generation,  Bulletin,  National  Association  of  Credit  Men, 
Vol.  XIX,  p.  935. 

2  E.  Naumburg,  AnnaUst,  Vol.  Ill,  No.  62,  March  23, 1914,  p.  361. 


RECENT  CHANGES  IN  CREDIT  ARRANGEMENTS     125 

paper,  with  a  heavy  sprinkling  of  endorsed  trade  paper 
and  acceptances,  bulked  large  in  bankers'  receivables 
before  the  disturbing  effects  of  the  Civil  War  were 
felt. 

The  evolution  from  this  system  of  endorsed  accom- 
modation paper  and  endorsed  trade  paper,  i.  e.,  notes 
given  by  buyer  to  seller  and  endorsed  by  the  latter, 
was  to  discount  chiefly  double  name  commercial  paper 
representing  bona  fide  business  transactions  and  given 
for  value  received  in  merchandise.  Under  this  system, 
which  reached  its  culmination  about  1880  accommoda- 
tion paper  was  regarded  as  dangerous  and  was  dili- 
gently eschewed.  But  in  spite  of  the  best  efforts  of 
the  bankers,  accommodation  paper  continued  to  be 
floated.  Notes  originally  given  for  merchandise  pur- 
chased became  after  several  renewals  the  worst  kind  of 
accommodation  paper  because  they  enabled  the  bor- 
rowing customers  of  a  bank  to  carry  along  delinquent 
debtors  indefinitely.^ 

Then  developed  in  trade  the  present  discount  system 
under  which  merchandise  or  manufactured  wares  are 
sold  subject  to  a  discount  for  cash  or  for  a  short  term 
pa^Tnent,  goods  being  billed  on  open  account.  In 
order  to  take  advantage  of  the  liberal  discounts  offered 
for  cash  or  early  payment,  merchants  and  manufac- 
turers were  under  a  strong  incentive  to  borrow,  and 
did  borrow,  from  at  first  the  bolder  and  later  from  even 
the  most  conservative  bankers,  on  unsecured  single 
name  paper.  The  theory  is  that  business  concerns 
should  buy  their  merchandise  or  raw  materials  as 
nearly  for  cash  as  possible  and  borrow  directly  or  in- 
1  Cf.  James  B.  Forgan,  op.  cit.,  p.  936. 


126  BANK  CREDIT 

directly  from  banks  to  enable  them  to  do  so.^  This 
system  developed  mitil  it  has  become  so  general  a 
practice  that  we  may  profitably  note  the  forces  under- 
IjTng  its  development. 

The  Civil  War  with  the  greenbacks  depreciated  and 
fluctuating  in  value,  and  the  demand  for  commodities 
outninning  supply,  induced  a  marked  shortening  of 
the  credit  period,  to  thirty  or  even  ten  days.  The 
system  thus  inaugurated  became  a  settled  trade  cus- 
tom in  connection  with  which  manufacturers  and  dis- 
tributers began  about  ISSO  to  offer  large  discounts  for 
cash  pajTnent.  Competition  in  the  eighties  among  our 
rapidly  growing  producing  and  marketing  agencies 
resulted  in  the  practice  of  selling  through  travehng 
salesmen  and  bj"  sample.  The  buyer  no  longer  found  it 
desirable  to  \'isit  the  seller's  store  and  to  purchase  from 
a  stock  of  goods  prepared  in  advance,  and  the  old 
condition  of  ''caveat  emptor"  gave  way  to  the  doctrine 
of  implied  warranties.  In  other  words  the  risk  and 
responsibility  of  the  delivery  was  laid  upon  the  seller 
instead  of  on  the  buyer,  the  buyer  no  longer  consenting 
to  fixing  the  price  of  the  merchandise  so  firmly  as  to 
preclude  the  possibiUty  of  claims  in  deduction  from  the 
account.  The  doctrine  of  implied  warranties  and  the 
open  account  came  fonvard  hand  in  hand.  Once  the 
practice  of  selling  on  open  account  was  established,  it 
was  natural  for  sellers  to  stimulate  promptness  by 
offering  liberal  cash  discounts.  The  introduction  of 
discounts  for  cash,  which  took  place  in  the  early  eight- 
ies, when  growing  competition  among  sellers  tended  to 
lengthen  the  credit  period,  impelled  buyers  to  borrow 
1  Ibid.,  p.  936. 


RECENT  CHANGES  IN  CREDIT  ARRANGEMENTS     127 

directly  from  their  banks  in  order  to  take  advantage 
of  the  discounts  offered.^ 

The  system  of  borrowing  by  the  buyer  on  his  own 
responsibiUty,  which  was  a  consequence  of  the  intro- 
duction of  cash  discounts,  has  in  the  minds  of  many 
proved  superior  to  the  old  methods  of  endorsed  paper, 
which  involved  so  many  borrowers  in  complications 
and  often  led  to  the  hiding  of  assets  by  endorsers  to 
avoid  the  paj-ment  of  obhgations  from  which  they  had 
received  no  benefit. 

Although  the  introduction  of  the  practice  of  financ- 
ing trade  by  single  name  paper  has  been  referred  to  as 
occurring  in  the  eighties  of  the  last  century,  it  would  be 
wTong  to  suppose  that  single  name  paper  had  not 
been  employed  here  and  there  previously.  Shortly 
after  the  crisis  of  1873  banks  in  New  York  City  began 
to  discount  single  name  paper  for  their  customers, 
even  though  such  notes  had  been  sold  to  banks  by 
brokers  much  earher.  The  late  president  of  the  Im- 
porters and  Traders  Bank  of  New  York,  Mr.  Buell,  is 
frequently  referred  to  as  the  pioneer  in  this  field.  He 
showed  his  customers  the  advantage  of  borrowing  on 
their  general  credit  standing  in  order  to  obtain  cash 
prices  on  their  purchases  and  thus  show  a  margin  of 
profit  on  their  discount  transactions.^ 

The  first  detailed  classification  of  the  loans  of  New 
York  banks  contained  in  the  Reports  of  the  Comp- 
troller of  the  Currency  is  for  the  year  1874  and  shows 

» Edward  D.  Page,  Annalist,  March  16,  1914,  Vol.  Ill,  No.  61, 
pp.  324,  325. 

*  J.  J.  Klein,  Commercial  Importance  of  Single  Name  Paper, 
Annalist,  Vol.  Ill,  No.  62,  March  23,  1914,  p.  361. 


128 


BANK  CREDIT 


100 


90 


Pe/z  Cent 
wo 


9o 


80 
70 
60 
SO 
40 
30 
20 
JO 


1 

£nDO/ZS£'D  PaP£/2 

Secu/ea 

'D  Loan 

'S. 

i 



>v 

/ 
/ 
/ 

\ 

» 

/ 

■        N 

\ 

/ 

/ 

X 

/ 

\ 

1 

\ 

> 

V 

/ 

^ 

/ 

. 

/ 

**>. 

/ 

N 

/ 
/ 

^v 

/ 

N^ 

/ 

N 

/ 

' 

/ 

\ 

' 

\ 
\ 

_^^-<7;. 

:::::::: 

^ 

<9^ 


70 


GO 


SO 


40 


30 


20 


JO 


levs     jaeo      zees     raao      jaas     taoo     /sos     t9io     i9rs 
Diagram  5 

that  single  name  paper  in  that  year  constituted  9.8  per 
cent  of  the  total,  and  endorsed  paper,  57.8  per  cent  of 
the  total.  The  relative  importance  of  the  main  kinds 
of  loans  of  the  national  banks  of  New  York,  1875-1914, 
is  shown  by  diagram  5,  and  of  the  national  banks  of 
the  entire  country,  for  the  period  1880-1914,  by  dia- 


RECENT  CHANGES  IN  CREDIT  ARRANGEMENTS  129 


PEJZCSNt 
fOQ 


90 


60 


100 


eNOo/ssEO  Papejz 

SING(L£  J^AME  fkPEA. 

Secc/R£o  Loans 


90 


eo 


10 


€0 


50 


40 


so 


20 


to 


7660       zees      reso       ress      /aoo      /9os      J310      79J^ 

Diagram  6 

gram  6. ^  Changes  in  the  classification  of  loans  after  19 14 
render  the  extension  of  the  curves  beyond  that  year 
impracticable. 

» In  drawing  the  chart  of  loans  of  all  national  banks  it  has  been 


130  BANK  CREDIT 

State  banks  and  trust  companies  show  a  strikingly 
smaller  percentage  of  both  single  name  and  of  endorsed 
paper  than  do  national  banks.  The  ratio  of  single 
name  paper  to  total  loans  of  state  banks  and  trust 
companies  in  1910  was  only  a  scant  10  per  cent,  and 
endorsed  paper  constituted  approximately  15  per  cent, 
of  the  total.  Loans  secured  by  collateral  in  the  case  of 
state  banks  and  trust  companies  were  29  per  cent  of  the 
total,  whereas  the  same  class  of  loans  made  by  national 
banks  was  36  per  cent  of  the  total.  Loans  on  real  estate 
combined  •^dth  mortgages  owned  by  state  banks  and 
trust  companies,  on  the  other  hand,  constituted  38.1 
per  cent  of  their  total  loans.  ^  The  paper  held  by  state 
banks  and  trust  companies  is  even  less  strictly  ''com- 
mercial" and  liquid  in  its  nature  than  that  held  by 
national  banks. 

Closely  related  to  the  evolution  of  the  form  of  the 
bank  borrower's  obhgation  is  the  rise  and  development 
of  note  brokerage  as  a  system  of  buying  and  selhng 
both  secured  and  unsecured  paper, — but  payable  al- 
found  advisable,  on  account  of  classification  changes  made  in  the 
Reports  of  the  Comptroller  of  the  Currency,  to  estimate  the  amount 
of  endorsed  paper  for  the  period  1880  to  1888.  The  margin  of  error, 
however,  is  ahnost  negUgibly  small.  For  the  period  1891  to  1914  the 
item  "on  demand,  paper  with  one  or  more  individual  or  firm 
names"  was  di\dded  arbitrarily  and  equally  between  endorsed  paper 
and  single  name  paper. 

In  the  classification  of  loans  of  the  national  banks  of  New  York 
City  1875  to  1890,  loans  classified  as  "payable  in  gold"  and  "all 
other  loans,"  together  amounting  to  approximately  4  per  cent  of  the 
total,  were  discarded.  For  the  period,  1891  to  1914,  the  item  "on 
demand,  paper  with  one  or  more  individual  or  firm  names"  was 
divided  equally  as  above  between  endorsed  and  single  name  paper. 

*  Report  of  the  Comptroller  of  the  Currency,  1910,  p.  55. 


RECENT  CHANGES  IN  CREDIT  ARRANGEMENTS  131 

ways  on  time,  never  on  demand.  As  the  following 
pages  will  show,  the  beginnings  of  the  note  brokerage 
system  reached  back  far  into  the  last  century. 

The  Growth  of  Note  Brokerage 

The  development  of  the  work  of  note  brokerage  or 
commercial  paper  houses  in  the  United  States  has  pro- 
ceeded a  long  way  without  having  attracted  much 
serious  attention.  Handling  wares  of  little  bulk  in 
proportion  to  value,  occupying  relatively  small  and 
inconspicuous  quarters,  and  seldom  attempting  to 
secure  publicity  through  the  medium  of  advertising, 
note  brokerage  concerns  have  come  in  large  measure 
unobserved  to  occupy  an  important  and  unique  place 
in  our  credit  organization. 

For  at  least  twenty-five  years  before  the  outbreak 
of  the  Civil  War  a  small  class  of  dealers  handled  trade 
acceptances  and  receivables  chiefly  on  a  commission 
basis.  Mr.  Henry  Clews,  whose  banking  and  brokerage 
house  was  the  first  in  New  York  City  to  introduce  the 
practice  of  buying  these  obligations  outright  has  given 
an  account  of  the  work  of  the  ante-bellum  dealers  that 
is  so  pertinent  and  illuminating  as  to  deserve  reproduc- 
tion. 

At  the  time  I  visited  Washington  [in  1861]  my  firm  was 
more  largely  engaged  in  dealing  in  mercantile  paper  than 
any  other  branch  of  Wall  Street  business. 

I  had  inaugurated  the  system  at  the  time  of  my  advent 
to  the  "Street"  of  buying  merchants'  acceptances  and  re- 
ceivables out  and  out,  the  rate  being  governed  by  the  pre- 
vailing ruling  rate  for  money,  with  the  usual  commission 
added. 


132  BANK  CREDIT 

It  was  by  this  method  that  my  firm  soon  became  the  largest 
dealers  in  mercantile  paper,  which  business  had  formerly  been 
controlled  by  two  other  firms  for  at  least  a  quarter  of  a  cen- 
tury, and  whose  old  fogy  methods  were  by  my  innovations 
easily  eclipsed. 

The  merchants  at  that  time  would  go  to  these  discount 
firms  and  leave  their  receivables,  bearing  their  endorse- 
ments, on  sale  there,  and  only  when  sold  by  piecemeal  could 
they  obtain  the  avails  thereof. 

The  more  expeditious  plan  that  I  adopted,  which  was  to 
give  these  negotiators  a  check  at  sight,  seemed  generally  to 
merit  their  approbation,  and  enabled  me  to  command  the 
situation  in  that  line  of  business,  very  much  to  the  chagrin  of 
my  competitors. 

In  this  way  my  firm  had  accumulated  about  five  hundred 
thousand  dollars  in  notes,  which  were  hypothecated  with 
various  city  and  country  banks. 

After  coming  to  the  conclusion  ...  in  regard  to  the  cer- 
tainty of  a  .  .  .  prolonged  and  desperate  war,  I  made  quick 
steps  back  to  New  York  to  dispose  of  my  paper.  I  went 
vigorously  to  work,  and  succeeded  in  unloading  all  but  ten 
thousand  dollars  of  short  time  notes  made  by  Lane,  Boyce  & 
Co.,  and  a  note  of  $500  of  Edward  Lambert  &  Co. 

I  had  no  sooner  accomplished  this  very  desirable  work  of 
shifting  my  burden,  and  distributing  it  in  a  more  equable 
manner  on  the  shoulders  of  others,  but  at  higher  rates  than  I 
paid,  than  in  less  than  a  week  after  my  return  from  Washing- 
ton the  exciting  news  arrived  of  the  firing  of  the  first  hostile 
gun  at  Fort  Sumter. 

The  announcement  of  this  overt  act  of  war  spread  like 
wildfire,  and  the  wildest  scenes  of  excitement  and  consterna- 
tion were  witnessed  in  Wall  Street  and  throughout  the  entire 
business  community.  The  whole  country  was  panic  stricken 
in  an  instant.  ... 


RECENT  CHANGES  IN  CREDIT  ARRANGEMENTS  133 

The  two  firms  whose  paper  I  was  unable  to  dispose  of  were 
about  the  first  to  fail,  and  before  the  maturity  of  any  of  the 
balance  of  the  paper  which  I  had  successfully  negotiated  both 
the  drawers  and  endorsers  thereon,  without  an  exception,  all 
collapsed.* 

The  financial  and  trade  disturbances  of  the  Civil 
War  did  not  end  with  its  termination  and  the  commer- 
cial paper  business  was  of  slender  proportions  during 
the  period  of  the  inconvertible  greenback,  1862-1878. 

During  the  greenback  period  fluctuations  in  the 
value  of  irredeemable  currency  made  the  extension  of 
credit  for  any  considerable  length  of  time  extremely 
risky.  The  approach  of  the  resumption  of  specie  pay- 
ments was  the  signal  for  resuming  the  practice  of  sell- 
ing goods  on  long  time,  and  as  the  volume  of  notes 
and  accounts  receivable  grew  under  the  influence  of 
lengthening  credit  terms,  business  concerns  were  im- 
pelled either  to  borrow  from  banks  or  sell  their  own 
paper  through  note  brokers. 

During  the  eighties  great  progress  occurred  in  the 
development  of  note  brokerage.  Before  the  close  of 
the  decade  of  the  eighties  paper  dealers  doing  an  ex- 
tensive business  had  been  established  as  far  west  as 
Chicago,  Milwaukee,  Kansas  City,  St.  Louis,  St.  Paul, 
and  Minneapohs,  Over  thirty  millions  of  paper  was 
sold  by  one  western  house  previously  to  1887,  before 
a  single  default  in  payment  occurred.  ^ 

Prior  to  1895  or  1900  handling  paper  on  consign- 

1  Henry  Clews,  Fifty  Years  in  Wall  Street,  Irving  Publishing  Com- 
pany, 1908,  pp.  78,  79. 

*  W.  H.  Baker  and  H.  N.  Kingman,  Commeixial  Payer,  Proceed- 
ings, American  Bankers'  Association,  1887,  pp.  46,  47. 


134  BANK  CREDIT 

ment  was  very  common.  Since  that  time  the  practice 
has  fallen  increasingly  into  disfavor.  The  volume  of 
paper  handled  on  a  commission  basis  has  dwindled  and 
almost  disappeared.  Commercial  paper  houses  now 
buy  paper  outright  almost  invariably,  and  to  the 
extent  that  they  hold  it,  whether  through  choice  or 
necessity,  perform  a  banking  function.  Dealers  in 
paper  now  have  a  livelier  sense  of  responsibihty  for  its 
soundness  and  liquidity  than  when  they  worked  for 
a  commission. 

The  intersectional  activity  of  the  paper  dealers  was 
slow  in  developing.  As  late  as  1887  eastern  banking 
funds  were  still  confined  to  investment  in  eastern 
paper,  even  though  the  dealers  of  the  West  were  float- 
ing trade  paper  that  proved  attractive  to  the  banks  of 
that  section  at  a  time  when  accommodation  paper  was 
growing  rapidly  in  volume  in  the  East.  Eastern  banks 
preferred  "accommodation"  paper  to  the  receivables  of 
the  expanding  West.^ 

The  year  1890  marks  in  a  rough  way  the  breaking 
down  of  the  barrier  which  had  previously  prevented 
eastern  capital  from  flowing  to  the  West  through  the 
channels  afforded  by  the  note  brokers.  Just  at  the 
time  when  there  seemed  to  be  an  opportunity  for 
bankers  in  the  West,  the  Iowa  group  of  states,  to  dis- 
pose of  idle  funds  at  profitable  rates,  the  "festive" 
note  broker  made  his  presence  felt  in  banking  circles, 
disturbing  with  his  eastern  capital  the  harmonious  rela- 
tions between  banker  and  borrower.^    It  was  natural 

1  Op.  ciL,  p.  47. 

2  J.  K.  Deming,  Modem  Methods  of  Soliciting  Business,  Proceed- 
ings, Sixth  Annual  Meeting,  Iowa  Bankers'  Association,  1892,  p.  21, 


REGENT  CHANGES  IN  CREDIT  ARRANGEMENTS  135 

that  the  first  brokerage  connections  estabhshed  be- 
tween the  East  and  the  West  should  have  resulted  in  a 
flow  of  capital  westward. 

As  potential  borrowers  from  banks  in  any  particular 
locahty  sold  their  paper  more  and  more  through  note 
brokers,  surplus  funds  in  that  locality  accumulated, 
and  gave  birth  there  to  a  demand  for  broker's  paper. 
The  more  paper  the  brokers  obtained  through  solicita- 
tion or  otherwise,  the  greater  became  the  buying  de- 
mand of  the  banks.  The  situation  was  and  remains  a 
peculiar  one  and  goes  far  to  explain  the  rapid  spread  of 
the  note  brokerage  system. 

Although  the  volume  of  paper  placed  by  the  dealers 
had  reached  large  proportions  before  1900,  the  growth 
of  the  business  both  in  point  of  volume  and  territorial 
ramifications  since  that  date  has  overshadowed  its 
previous  development.  The  following  tabular  state- 
ment throws  light  on  the  expansion  of  the  operations 
of  paper  houses  into  sections  whose  economic  develop- 
ment has  occurred  largely  in  our  own  time,  and  shows 
how  in  certain  representative  localities  the  solicitation  of 
the  buying  departments  of  note  brokerage  concerns  paved 
the  way  for  the  paper  salesmen  in  the  same  localities. 

Approximate  date  of    Approximate  date  of 
City  first  sale  of  paper  first  sale  of  paper 

by  local  concerns  by  brokers  to  local 

to  brokers  banks 

Akron,  Ohio 1902 1906 

Columbus,  Ohio 1907 1912 

JoUet,  Illinois 1908 

Dallas,  Texas 1910 1910 

Portland,  Oregon 1906 1908 

Spokane,  Washington 1911 1911 


136  BANK  CREDIT 

The  a  priori  notion  that  the  purchase  of  paper  by 
brokers  must  have  created  a  demand  for  paper  on  the 
part  of  banks  whose  borrowing  customers  were  induced 
to  dispose  of  their  obhgations  through  brokers,  tallies 
with  the  contention,  based  in  part  on  the  table  given, 
that  the  market  for  the  wares  of  the  paper  dealer  was 
the  ine\dtable  product  of  his  own  buying  effort  and 
power.  There  were  of  course  many  exceptions.  Banks 
in  locaUties  haidng  a  widely  diversified  commercial  or 
industrial  development  vnih.  few  or  no  concerns  of 
sufficient  size  and  importance  to  borrow  through 
brokers  might  naturally  buy  broker's  paper  long  before 
customers  of  local  banks  were  led  to  place  paper  in  the 
open  market.  Banks  in  thrifty  towns  in  the  East  may 
have  found  a  natural  outlet  for  their  surplus  funds  in  the 
purchase  of  broker's  paper,  even  though  local  borrowing 
concerns  never  utilized  the  services  of  the  note  broker. 

In  some  instances  local  borrowing  demands  were  in 
excess  of  the  local  supply  of  short  time  funds  and  bor- 
rowers placed  paper  in  the  open  market  long  before  the 
banks  were  in  condition  to  buy  outside  paper.  St. 
Joseph,  Missouri,  affords  an  illustration.  The  jobbing 
houses  located  there  sold  their  paper  in  the  Eastern 
market  for  many  years  before  the  St.  Joseph  banks 
began,  about  1900,  to  purchase  commercial  paper 
offered  by  brokers.  The  bank  credit  demands  of  the 
jobbing  business  of  St.  Joseph  have  always  been  in 
excess  of  the  lending  facihties  of  the  local  banks,  and 
jobbers  using  a  great  deal  of  money  have  secured  funds 
through  the  sale  of  notes  placed  with  brokers,  and 
have  also  opened  accounts  in  New  York  and  other 
cities  in  order  to  obtain  larger  accommodation. 


RECENT  CHANGES  IN  CREDIT  ARRANGEMENTS     137 

The  situation  in  the  country  as  a  whole  was,  never- 
theless, one  where  the  soHcitation  of  paper  by  the 
brokers  had  ahnost  unique  results:  their  success  in 
weaning  customers  away  from  banks  was  productive 
of  a  corresponding  demand  for  the  very  paper  acquired 
by  soHcitation. 

The  extraordinary  growth  in  the  work  of  the  com- 
mercial paper  houses  during  the  last  quarter  century 
has  been  accomplished  without  a  corresponding  in- 
crease in  the  number  of  houses.  The  tendency  has 
been  for  the  stronger  houses  to  build  up  an  extensive 
system  of  branches  and  correspondents  covering  wide 
territory,  as  opposed  to  extension  through  an  increase 
in  the  number  of  individual  brokerage  concerns.  In 
some  cases  the  branch  principle  has  developed  to  a 
point  where  the  branches  participate  in  buying,  and 
there  is  a  general  trend  toward  concentration  of  the 
entire  business  in  a  few  hands.  Experience  has  led 
some  houses  maintaining  few  branches,  or  none  at  all, 
to  favor  distribution  through  correspondents  rather 
than  through  branches. 

Boston  has  at  present  six  local  houses  and  four  or 
five  branches  of  concerns  located  in  other  cities.  New 
York  has  a  total  of  twenty-three  houses,  many  of 
which,  as  elsewhere,  are  not  engaged  exclusively  in  the 
purchase  and  sale  of  commercial  paper,  but  handle 
stocks,  bonds,  foreign  exchange,  etc. 

The  modern  commercial  paper  house  is  a  somewhat 
complex  business  organization.  Buying,  credit,  and 
selling  departments  contribute  to  efficiency  and  sound- 
ness of  operation.  The  buying  department  is  charged 
with  finding  desirable  concerns  from  which  the  house 


138  BANK  CREDIT 

may  buy,  but  it  is  only  after  the  credit  department, 
employing  methods  and  having  interests  similar  to 
those  of  the  bank  credit  department,  has  approved  an 
advance  of  funds,  that  the  paper  is  bought.  The  sel- 
Ung  department  sells  both  ''by  list"  and  through  per- 
sonal solicitation.  A  large  proportion  of  the  paper 
handled  is  now  sold  by  traveling  representatives,  who 
work  in  regularly  assigned  territory. 

The  depleted  sales-forces  of  war-time  had  the 
volume  of  their  sales  affected  adversely  by  the  demands 
of  the  government  upon  the  loanable  funds  of  the 
banks,  and  many  of  the  salesmen  might  have  retired 
from  the  field  but  for  the  rediscount  facilities  afforded 
by  the  Federal  Reserve  system,  which  have  tended  to 
increase  the  amount  of  money  available  for  the  pur- 
chase of  the  note  broker's  offering. 

Seasonal  Demands  for  Funds  in  Relation  to  the  Growth  of 
Note  Brokerage 

The  rise  of  commercial  paper  houses  has  an  intimate 
connection  with  the  seasonal  character  of  the  demand 
for  funds  in  large  sections  of  the  country.  As  regularly 
as  seed  time  and  harvest  occurred  bankers  in  the 
agricultural  sections  of  the  country  found  it  desirable 
to  be  in  a  position  to  withdraw  or  secure  fujids  from 
other  than  local  sources  in  order  to  meet  the  local  de- 
mand. In  other  words,  it  was  the  business  and  duty  of 
the  banks  in  the  agricultural  sections  so  to  time  their 
loans  and  so  to  make  their  investments  of  surplus  funds 
as  to  meet  these  recurring  seasonal  demands  with  cer- 
tainty and  without  disarrangement  of  local  credits. 
No  form  of  investment  filled  the  requirements  of  the 


RECENT  CHANGES  IN  CREDIT  ARRANGEMENTS  139 

case  so  well  as  selected  notes  of  distant  concerns. 
Twenty  years  ago  when  loans  were  almost  entirely 
local,  surplus  funds  of  country  banks  were  invested 
largely  in  high  class  bonds  and  similar  securities,  which 
were  held  with  the  idea  of  sale  when  the  local  demand 
for  funds  outran  the  local  supply.  A  bank  holding 
such  securities,  however,  had  no  disposition  to  sell 
them  until  money  became  scarce.  But  it  was  at  just 
such  times  that  the  security  market  became  unfavor- 
able and  restricted.  Banks,  having  found  the  extensive 
holding  of  securities  for  such  purposes  unprofitable  and 
undesirable,  invested  their  surplus  funds  more  and 
more  in  paper  offered  by  note  brokerage  houses.  The 
demands  upon  commercial  banks  which  necessitated 
their  carrying  increasingly  large  amounts  of  loans  the 
payment  of  which  could  be  counted  upon  with  cer- 
tainty was  long  one  of  the  chief  sustaining  forces  of  the 
note  brokerage  business.^ 

Independent  Banking  and  the  Rise  of  Note  Brokerage 

The  growth  of  the  note  brokerage  business  and  the 
prominent  role  now  played  by  the  note  broker  as  an 
intermediary  between  banks  and  borrowers  in  the 
United  States  are  closely  related  also  to  our  system  of 
independent  banks  without  branches.  American  banks 
having  loanable  funds  in  excess  of  local  demands  found 
it  natural  and  profitable  to  purchase  the  paper  of  bor- 
rowers in  other  communities  where  local  banks  were 
unable  to  meet  the  demands  of  their  customers.    This 

^  Cf.  Jos.  T.  Talbert,  Commercial  Paper,  Proceedings,  Nineteenth 
Annual  Convention,  Minnesota  Bankers'  Association,  1908,  pp.  42, 
44. 


140  BANK  CREDIT 

persistent  disparity  between  the  lending  power  of  local 
banks  and  the  effective  demand  for  bank  credit  has 
constituted  the  note  brokers'  opportunity,  and  the 
brokerage  houses  have  been  keenly  responsive  in 
affording  facilities  for  putting  banks  having  surplus 
funds  in  touch  with  distant  borrowers  in  need  of  short 
time  capital.  Had  we  developed  a  system  of  branch 
banks  the  supply  of  bank  credit  and  the  demand  for 
funds  would  have  been  equated  without  any  needed 
intervention  of  other  agencies.  The  branch  banking 
system  as  seen  in  England,  France,  Germany  and, 
even  more  strikingly,  in  Scotland  and  Canada,  not 
only  fm-nishes  the  mechanism  for  connecting  commu- 
nities widely  different  in  their  credit  needs  but  also  is 
capable,  by  reason  of  the  large  resources  of  the  individ- 
ual banks,  of  meeting  the  demands  of  hea\^"  borrowers, 
leaving  thereby  no  place  for  the  activity  of  paper  dealers. 

Commercial  paper  houses  as  intermediaries  between 
banks  and  borrowers  and  working  as  an  adjunct  to  our 
banking  system  promote  the  flow  of  funds  from  one 
point  or  section  where  the  demand  is  slight  to  other 
places  where  the  need  is  pressing,  distributing  loanable 
funds  in  a  manner  analogous  to  that  of  a  system  of 
branch  banks. 

There  is,  however,  one  important  point  of  difference. 
Branch  banking  so  equates  demand  and  supply  that 
every  part  or  unit  of  the  system  bears  its  proper  share 
of  strain  when  strain  comes.  The  note  brokerage  sys- 
tem, operating  as  an  adjunct  of  independent  banks, 
fails  thus  to  equaUze  the  pressure  or  strain.  Under 
our  system  of  note  brokerage  and  independent  banking 
those  banks  holding  a  minimum  of  local  loans  and  a 


RECENT  CHANGES  IN  CREDIT  ARRANGEMENTS  141 

maxiinum  of  broker's  paper  are  relieved  of  strain  in  a 
stringency,  while  others  with  less  paper  and  heavier 
local  loans  meet  the  demands  of  their  borrowers  with 
less  ease.  The  branch  banking  system  may  be  Hkened 
to  a  system  of  reservoirs  with  inter-connecting  pipes 
always  ample  and  unobstructed;  whereas  the  note 
brokerage  system,  while  always  constituting  channels 
for  the  inter-flow  of  short  time  capital  from  section  to 
section,  fails  to  function  efficiently  during  periods  of 
tight  money  and  crisis.  Then  the  flow  of  the  currents 
of  short  time  funds  becomes  impeded  and  disturbed. 

The  eight  Scotch  banks  with  their  branches  num- 
bering approximately  thirteen  hundred,  and  the  nine- 
teen chartered  banks  of  Canada  with  their  thirty-five 
hundred  branches  serve  adequately  as  collectors  of 
cash  and  distributers  of  credit.  The  paper  dealer  is  of 
no  importance  in  the  distribution  of  credit  in  France, 
and  plays  only  a  negligible  part  in  Germany.  The 
English  bill  brokers  and  discount  houses  perform  a 
function  similar  to  that  of  our  note  brokers,  but  are 
concerned  pretty  largely  with  bills  used  to  finance 
international  transactions.  "Wherever  branch  banking 
develops  widely  the  work  of  note  brokers  is  excluded  as 
supplementary  and  unnecessary.  There  is,  on  the  con- 
trary, a  natural  fitness  between  the  note  broker  and 
independent  local  banldng.  The  service  of  our  own 
note  brokers  is  not  supplementary  to  that  of  the  banks, 
but  complementary  and  economically  justifiable. 

The  New  Attitude  of  Bankers  toward  Broker's  Paper 

The  attitude  of  our  bankers  toward  broker's  paper 
has  undergone  a  radical  change  since  the  note  broker 


142  BANK  CREDIT 

first  came  prominently  forward  with  his  wares  twenty- 
five  years  ago.  Previously  to  the  panic  of  1907,  which 
subjected  commercial  paper  marketed  by  the  broker- 
age houses  to  a  crucial  test,  bankers  were  inchned  to 
shake  their  heads.  The  crisis  of  1907  and  the  events  of 
1914,  however,  demonstrated  strikingly  the  conver- 
tibiUty  of  broker's  paper,  and  bankers  have  been  in- 
creasingly friendly  to  it.  Probably  a  large  majority  of 
our  banks  as  measured  by  resources  now  resort  to  the 
commercial  paper  houses  with  much  regularity,  and 
many  continually,  in  order  profitably  to  utilize  idle 
funds,  to  enhance  the  convertibility  of  their  loans,  and 
to  scatter  their  risks  beyond  local  range. 

The  Rise  of  the  Credit  Department 

The  credit  department  of  a  bank  is  one  of  prime  im- 
portance. It  is  the  clearing-house  for  credit  informa- 
tion, the  headquarters  for  analysis  of  credit  risks,  a 
storehouse  of  facts  relating  to  borrowers  of  the  funds  of 
a  bank.  Men  in  charge  of  the  department  are  watch- 
dogs of  the  bank's  loans  and  the  guardians  of  the  in- 
vestments made  for  correspondents.  "The  depart- 
ment must  be  manned  by  our  most  faithful,  reliable, 
intelligent,  tactful  men,  who  must  be  capable  of  infinite 
pains,  of  inexhaustible  patience,  and  of  absolute 
loyalty.  Their  ears  and  eyes  must  be  open  to  every 
contingency  that  no  sign  may  go  unheeded.  They  are 
compelled  to  walk  in  the  ruts  of  routine  and  yet  be 
pathfinders  constantly.  No  man  who  works  mechani- 
cally will  develop  into  a  successful  credit  man.  The 
credit  department  should  have  an  equipment  com- 


RECENT  CHANGES  IN  CREDIT  ARRANGEMENTS  143 

mensurate  with  its  importance.  It  should  be  the 
inner  chamber  in  all  respects.  ...  Its  mechanism  of 
blanks,  files,  vaults  and  office  fixtm-es  should  be 
perfectly  adapted  to  its  service,  and  every  means 
that  ingenuity  can  devise  should  be  utilized  to  assist 
its  work."^  . 

A  high  state  of  development  of  the  credit  depart- 
ment has  been  reached  chiefly  in  our  leading  cities, 
but  with  the  growth  of  commercial  and  industrial 
centers  credit  departments  are  being  organized  in 
smaller  and  smaller  places.  Many  country  banks  keep 
elaborate  credit  files  without  maintaining  a  credit 
department  as  a  distinct  unit  in  their  organization. 
The  ordinary  credit  system  is  elastic  and  forms  multi- 
ply as  needs  expand  until  facts  may  be  easily  gathered 
from  many  sources,  summarized  and  digested  for  ready 
use. 

The  credit  department  of  the  metropolitan  bank  may 
utilize  the  services  of  upwards  of  a  hundred  persons. 
Some  of  them  devote  their  time  to  indexing  and  filing 
information,  while  others  do  nothing  but  keep  the 
folders  in  proper  shape,  with  the  paper  fastened  into  the 
folder  so  that  it  may  be  handled  and  read  like  a  book. 
Investigators  who  are  employed  to  gather  information 
from  local  houses  in  specific  lines  of  business  assigned 
to  them  develop  into  specialists  and  become  reposi- 
tories of  facts  and  gossip  for  the  whole  trade.  The 
results  of  their  work  are  turned  in  to  members  of  the 
office  force  who  have  been  engaged  on  other  phases  of 
the  same  investigations.     The  whole  is  then  digested 

1  J.  G.  Cannon,  Bank  Credits,  Bankers'  Magazine  (New  York), 
Vol.  LXX,  May,  1905,  p.  587. 


144  BANK  CREDIT 

for  the  use  of  the  bank  or  dictated  as  a  letter  to  an 
inquiring  correspondent,  as  the  case  may  be.^ 

The  First  Phase  of  the  Development  of  Credit  Research 

The  estabhshment  of  credit  departments  in  Ameri- 
can banking  institutions  dates  from  about  1890.  The 
exact  date  of  the  estabhshment  of  the  first  department 
as  a  distinct  entity  in  the  work  of  a  bank  is  not  known 
to  the  writer  but  it  took  place  somewhat  previously  to 
1892.  On  November  17,  1892,  Mr.  James  G.  Cannon 
delivered  an  address  on  "Bank  Credits"  at  Drexel 
Institute,  Philadelphia, — probably  the  first  practical 
discussion  of  the  subject — in  which  he  stated  that 
there  were  then  not  more  than  a  half  dozen  credit 
departments  in  as  many  banks  in  the  United  States. 

Mr.  E.  S.  Lacey  testified  also  in  1892  with  reference 
to  the  rise  of  the  credit  department.  He  pointed  out 
that  large  city  banks  were  then  regarded  as  not  abreast 
of  the  times  which  did  not  possess  "complete  credit 
bureaus."  Time  and  money  were  being  spent  freely 
and  increasingly  "by  progressive  institutions  in  our 
larger  cities"  with  results  demonstrating  that  no  ex- 
penditure brought  larger  returns.^ 

Mr.  Cannon  was  an  earnest  advocate  of  the  advan- 
tages of  a  credit  department  in  the  work  of  a  bank  and 
was  very  active  and  effective  in  spreading  his  knowl- 

1  Freas  Brown  Snider,  The  Development  of  the  Credit  Department 
of  the  Bank,  Bulletin,  National  Association  of  Credit  Men,  Vol.  XIX, 
p.  948. 

2  E.  S.  Lacey,  Some  Phases  of  Modern  Banking,  Proceedings, 
Second  Annual  Convention  Bankers'  Association  of  the  State  of 
IlUnois,  1892,  p.  49. 


RECENT  CHANGES  IN  CREDIT  ARRANGEMENTS  145 

edge  and  enthusiasm.  The  subject  of  bank  credits 
was  discussed  before  many  state  bankers  associations 
diu-ing  the  mid- and  late  nineties,  and  the  close  of  the 
last  century  witnessed  the  successful  operation  of  a 
growing,  if  not  large,  number  of  well  organized  credit 
departments.  The  Fourth  National  Bank  of  New 
York,  of  which  Mr.  Cannon  was  for  many  years  vice- 
president,  and  which  was  later  absorbed  by  the  Me- 
chanics and  Metals  National  Bank,  was  the  first,  it 
appears,  to  establish  such  a  department.  The  Chase 
National  Bank  and  the  National  Park  Bank  were  also 
pioneers,  followed  by  the  National  City  Bank  in  1898, 
the  National  Bank  of  Commerce  about  1900  and  the 
First  National  Bank  of  New  York  two  years  later. 
The  movement  seems  to  have  had  its  inception  in  New 
York.  That  it  did  not  acquire  extraordinary  momen- 
tum during  the  last  decade  of  the  last  century  is  at- 
tested by  the  fact  that  such  leading  Boston  banks  as 
the  National  Shawmut  and  the  First  National  Bank  of 
Boston  did  not  institute  credit  departments  until  1903. 
Several  leading  banks  in  Philadelphia  established  reg- 
ular and  well  equipped  departments  in  the  opening 
years  of  the  present  century. 

Coincident  with  the  rise  of  the  credit  department 
was  the  agitation  carried  on  concerning  the  rendering 
of  signed  statements  of  condition  by  borrowers.  The 
executive  committee  of  the  New  York  State  Bankers' 
Association  adopted  resolutions  recommending  to  its 
members  ''that  they  request  borrowers  of  money  from 
their  respective  institutions  to  give  them  written 
statements  over  their  signatures  of  their  assets  and 
liabilities,  in  such  form  as  the  committee  on  uniform 


146  BANK  CREDIT 

statements  of  the  various  groups  might  recommend.'' 
Nearly  all  of  the  groups  of  the  New  York  State  Bank- 
ers'  Association  adopted  uniform  statement  blanks  and 
the  example  thus  set  was  followed  by  many  associa- 
tions in  other  states.^ 

In  1898  the  National  Association  of  Credit  Men, 
even  then  a  powerful  organization  of  nearly  three 
thousand  members,  adopted,  after  a  year's  investiga- 
tion of  the  subject,  uniform  statement  blanks  which 
were  widely  employed  from  the  outset.^  Only  a  year 
later  the  American  Bankers  Association,  in  a  conven- 
tion assembled  at  Cleveland,  adopted  a  uniform  prop- 
erty statement  blank  to  be  supphed  to  members.  As 
if  to  place  the  full  stamp  of  its  approval  on  credit 
departments  for  banks,  it  instructed  its  secretary  to  set 
up  in  his  office  a  model  department,  and  to  furnish 
members  information  in  regard  to  the  working  of  the 
same. 

These  efforts  constitute  what  may  be  called  the  first 
phase  of  the  development  of  credit  research.  The  close 
of  the  last  century  witnessed  firm  foundations  laid  and 
conditions  that  were  highly  favorable  to  the  extension 
of  the  work  of  careful  investigation  of  borrowing  con- 
cerns and  systematic  recording  of  the  information  se- 
cured. 

The  Development  of  the  Credit  Department  since  1900 

Since  1900  there  has  been  a  steady  and  enormous 
growth  in  the  number  of  credit  departments  in  banks, 
in  the  volume  of  their  work,  and  in  the  thoroughgoing 

1  J.  G.  Cannon,  Bank  Credits,  Bankers'  Magazine  (New  York), 
May,  1905,  Vol.  LXX,  p.  586.  ^  Ihid. 


RECENT  CHANGES  IN  CREDIT  ARRANGEMENTS  147 

and  really  scientific  character  of  the  work  of  investiga- 
tion. The  way  in  which  the  importance  of  adequate 
and  systematically  recorded  credit  information  has 
been  recognized  geographically  and  chronologically 
since  1900  may  be  made  plain  by  the  following  tabular 
statement : 

Year  When  Credit  Department 
Name  of  Bank  Was  Recognized  as  a  Dis- 

tinct   Unit    in    the   Bank's 
Organization 

Corn  Exchange  National,  Chicago 1900 

First  National,  Denver,  Col 1903 

Tootle-Lacy  National,  St.  Joseph,  Mo 1904* 

National  Bank  of  Commerce,  St.  Louis 1905 

Whitney-Central  National,  New  Orleans 1906* 

First  National,  San  Francisco 1907 

Fourth  National,  Atlanta,  Ga 1908 

Southwest  National  Bank  of  Commerce,  Kansas 

City,  Mo 1909 

Merchants-Mechanics    First    National,    Balti- 
more, Md 1910 

Seattle  National  Bank,  Seattle 1910 

Mississippi  Valley  Trust  Company,  St.  Louis 1911 

United  States  National,  Portland,  Ore 1912 

Lowry  National  Bank,  Atlanta,  Ga 1914 

National  Reserve  Bank  of  Kansas  City 1915 

Atlantic  National  of  Jacksonville,  Fla 1917 

The  period  before  1900  was  essentially  one  of  pio- 
neering. Since  that  date  the  frontier  of  the  advancing 
movement  has  disappeared,  and  we  may  now  expect 
an  intensive  development  of  the  credit  department  and 
its  methods  throughout  the  entire  country. 

*  Date  is  approximate. 


148  BANK  CREDIT 


The  Underlying  Forces 


The  conditions  or  forces  that  underlay  the  rise  and 
development  of  the  bank  credit  department  have  been 
nmnerous.  First,  perhaps,  in  point  of  time,  was  a 
gradual  change  of  method  employed  in  the  buying  and 
selhng  of  commercial  paper.  Borrowers  were  discov- 
ering that  it  was  disadvantageous  and  frequently 
impracticable  to  confine  themselves  to  one  bank  or  to 
one  place.  Merchants  and  manufacturers  went  away 
from  home  to  borrow  and  bankers  went  away  from 
home  to  procure  investments.  Bankers  feeUng  that  it 
would  be  inadvisable  to  break  the  rate  locally  would 
send  to  the  large  money  centers  and  buy  from  note 
brokerage  houses  the  paper  of  even  their  home  cus- 
tomers at  a  lower  rate  than  that  at  which  they  felt 
they  could  discount  the  note  directly.  A  small  fraction 
of  one  per  cent  was  sufficient  to  take  many  business 
men  from  home  for  their  accommodation.  The  prac- 
tice grew  for  banks  in  the  larger  cities  to  buy  or 
''check"  commercial  paper  for  their  country  correspond- 
ents and  it  became  more  and  more  imperative  for 
the  larger  city  banks  to  be  well  informed  in  the  widest 
possible  manner  with  reference  to  the  credit  of  borrowers, 
especially  of  sellers  of  commercial  paper  through  the  note 
brokerage  houses.  A  well  equipped  credit  department, 
in  short,  became  essential  to  the  profitable  operation  of 
a  large  number  of  metropolitan  and  other  banks  ha\'ing 
numerous  connections  with  smaller  institutions  whose 
credit  ascertaining  facilities  were  purely  local  in  scope. 

The  service  rendered  by  the  city  banks  was  practi- 
cally gratuitous.    Charges  were  seldom,  if  ever,  made. 


RECENT  CHANGES  IN  CREDIT  ARRANGEMENTS  149 

But  the  ability  and  willingness  of  the  city  bank  to  fur- 
nish the  desired  information  to  its  country  corre- 
spondents was  a  magnet  attracting  new  accounts  and 
holding  old  ones  against  a  growing  competition.^ 

It  must  not  be  understood  that  the  work  of  commer- 
cial paper  houses  led  to  the  estabhshment  of  credit 
departments  by  only  those  city  banks  whose  customers 
were  in  large  part  made  up  of  correspondent  banks. 
Banks  like  the  Fourth  National  of  New  York,  whose 
customers  were  chiefly  merchants  and  manufacturers, 
early  found  the  need  of  improved  credit  methods  im- 
perative in  passing  upon  outside  paper. 

Paper  buying  banks  maintaining  well  organized 
credit  departments  have  a  distinct  advantage  in  being 
able  to  act  both  quickly  and  advdsedly.  When  the 
money  market  is  dull  and  paper,  for  the  time  being, 
comparatively  scarce,  names  of  the  first  rank  are  se- 
ciu-ed  by  those  buyers  able  to  give  immediate  accep- 
tance. As  a  broker  acquainted  with  the  individual 
demands  of  his  constituents  can  at  times  easily  dispose 
by  telephone  of  a  million  dollars  in  choice  paper  in  a 
few  minutes,  the  value  of  a  quick  decision  is  evident.- 

1  Banks  in  the  larger  cities  are  asked  at  times  to  purchase  paper 
for  the  account  of  their  correspondents.  More  frequently  they  are 
requested  by  their  correspondents  in  the  country  to  secure  lists  of 
offerings  from  note  brokers  and  to  check  the  names  that  are  con- 
sidered good.  The  lists  after  being  checked  are  sent  to  the  inquiring 
banks  which  generally  buy  the  paper  selected  directly  from  the 
brokers.  Ordinarily  detailed  reports  are  not  given  in  connection 
with  the  names  checked,  as  is  true,  commonly,  when  paper  is  bought 
outright  by  the  city  bank  for  its  correspondent. 

2  William  Post,  The  Loan  and  Credit  Department,  Bulletin  of 
American  Institute  of  Bank  Clerks,  Vol.  Ill,  p.  137. 


150  BANK  CREDIT 

With  the  rapid  growth  of  our  cities  and  the  growing 
disposition  of  an  increasing  number  of  borrowers, — 
merchants,  manufacturers,  contractors,  promoters, 
capitaUsts,  and  banks  themselves, — to  use  borrowed 
funds,  the  borrowing  demands  upon  banks  became  so 
hea\'y  that  an  individual  officer,  unaided  by  facihties 
for  collecting,  systematizing  and  preserving  credit 
information,  was  incapable  of  meeting  the  require- 
ments of  his  bank.  The  cashier  or  other  officer  could 
no  longer  carry  "in  the  head  "  the  multiphcity  of  details 
touching  the  credit  standing  of  borrowers.  Not  only 
did  it  become  more  and  more  difficult  to  know^  each 
borrower  personally  as  population  grew  in  num- 
bers and  density,  but  his  affairs  became  less  and  less 
exposed  to  view.  It  was  natural  under  these  circum- 
stances that  well  equipped  credit  departments  should 
have  been  instituted  and  placed  in  charge  of  men 
specially  qualified  for  credit  work. 

Another  factor  underlying  the  estabhshment  and 
growth  of  the  credit  department  was  the  spread  of  the 
corporate  form  of  organization  during  the  nineties  and 
in  later  years.  As  the  growth  in  the  number  of  corpora- 
tions and  the  increased  size  of  the  business  unit, 
whether  firm  or  corporation,  took  place,  the  lending 
capacity  of  the  relatively  small  individual  bank  was 
outstripped.  But  the  growth  in  the  size  of  business 
corporations  prompted  a  corresponding  increase  in  the 
lending  capacity  of  banking  institutions  in  order  that 
each  bank  might  have  sufficient  capital  and  surplus  to 
enable  it  legally  to  meet  the  needs  of  its  more  promi- 
nent customers.  In  many  places  banks  found  that  the 
pro\dsion  of  the  National  Bank  Act  which  limits  indi- 


RECENT  CHANGES  IN  CREDIT  ARRANGEMENTS  151 

vidual  lines  of  credit  to  one-tenth  of  the  paid-up  capital 
and  surplus  hampered  their  activity  in  such  a  way  as 
to  suggest  an  enlarged  capital  and  surplus  as  the  legal 
basis  of  lending  capacity  adequate  to  meet  the  needs  of 
their  biggest  borrowers.  Growth  in  the  size  of  banks 
and  in  the  volume  of  their  loans  prompted  the  system- 
atic collection  and  handling  of  credit  information. 

ReUef  from  the  restrictive  loan  requirements  of  our 
banking  laws  was  found  in  many  cases  in  bank  consolida- 
tions which  still  further  promoted  the  credit  department 
movement.  In  numerous  cases  of  consolidation  the  need 
of  a  credit  department  was  felt  in  order  that  credit  infor- 
mation, indifferently  gathered  and  filed  previously  might 
be  focalized  and  handled  systematically  and  efficiently 
in  accordance  with  the  newer  and  larger  needs. 

In  another  and  quite  different  way  the  corporate 
form  of  business  organization  has  contributed  to  the 
establishment  of  elaborate  means  and  methods  of 
obtaining  and  handling  credit  information.  The  rise 
of  the  corporation  at  once  eliminated  in  large  measure 
the  personal  and  friendly  element  between  debtor  and 
creditor  and  afforded  a  screen  for  personal  credit  and 
personal  honor.  As  the  soulless  corporation  supplanted 
the  partnership,  men  struggled  less  energetically  to 
keep  their  family  honor  and  name  from  the  records  of 
the  bankruptcy  court.  Stockholders  and  managers 
of  corporations  had  less  incentive  to  pay  their  debts  in 
full,  and  the  lending  bankers  were  subjected  to  greater 
labor  and  compelled  to  scrutinize  more  closely  in  order 
to  protect  themselves  from  loss.^ 

•  J.  G.  Cannon,  Credit,  Credit-Man,  Creditor,  Bankers'  Magazine 
(New  York),  Vol.  LIII,  p.  34. 


162  BANK  CREDIT 

There  is  no  doubt  that  actual  losses  occurring  under 
the  old  system,  or  lack  of  system,  have  been  an  imme- 
diate and  inciting  cause  of  action  taken  with  a  view  to 
the  installation  of  complete  credit  files,  'bosses  under 
the  old  system,"  says  one  banker  in  the  Northwest, 
*' proved  the  absolute  necessity  of  accurate  and  com- 
plete credit  data." 

In  some  instances  improved  facihties  for  the  pro- 
curing of  credit  information  have  themselves  been 
more  or  less  favorable  to  the  installation  of  credit 
departments,  while  the  requirements  of  the  Federal 
Reserve  Act  that  all  paper  eligible  for  rediscount  must 
carry  a  statement  of  condition  of  the  maker  has  been 
decidedly  important.  The  installation  of  modern 
bank  credit  methods  has  been  advocated  by  bank  ex- 
aminers from  their  points  of  vantage,  in  and  out  of 
season. 

The  Rise  of  the  New  Business  Department  and  its 
Relation  to  the  Credit  Department 

The  aggressiveness  with  which  both  new  deposit  and 
loan  accounts  are  sought  marks  an  innovation  in 
American  banking.  A  large  number  of  new  accoimts 
are  to-day  obtained  by  energetic  personal  soUcitation. 
A  former  generation  regarded  this  beneath  the  dig- 
nity of  the  banking  profession,  but  a  new  day  has 
dawned. 

The  custom  of  sending  travehng  representatives  to 
secure  new  accounts  and  to  strengthen  old  ones  dates 
back  fifteen  or  twenty  years.  More  recently,  since 
about  1912,  new  business  departments  have  been  es- 
tabUshed  by  banks  in  the  large  cities,  where  one  or 


RECENT  CHANGES  IN  CREDIT  ARRANGEMENTS  153 

more  officers  are  charged  with  the  duty  of  building  up 
the  business,  and  to  this  end  call,  or  have  representa- 
tives call,  upon  existing  or  prospective  customers  and 
correspondents,  presenting  their  claims,  describing 
their  methods,  equipment  and  facihties.  At  the  same 
time  valuable  information  is  acquired  as  to  the  re- 
sources and  business  of  the  communities,  banks,  and 
business  concerns  visited.  A  capable  representative 
systematically  collects  a  vast  amount  of  highly  val- 
uable information  which  is  recorded  in  the  credit  files 
of  the  bank. 

The  work  of  the  new  business  department  dovetails 
with  that  of  the  credit  department.  It  has  been  natural 
for  the  bank  management  in  many  instances  to  utilize 
effectively  information  in  its  possession  concerning  the 
credit  worth  of  a  firm  or  corporation  that  gave  promise 
of  becoming  a  profitable  customer.  As  the  names  of 
desirable  prospective  customers  are  discovered  through 
the  activity  of  the  credit  department  of  the  bank  in  the 
larger  center,  steps  are  taken  by  the  new  business  de- 
partment toward  enrolling  those  names  on  the  ledgers 
of  the  bank.  If  some  banks  have  resisted  the  tempta- 
tion to  utilize  the  credit  department  in  the  compilation 
of  information  for  the  solicitation  of  new  business, 
allowing  that  department  to  focus  its  entire  attention 
on  the  standing  of  makers  of  paper  under  discount  in 
the  particular  institutions,  others  have  not. 

It  sometimes  occurs  that  new  accounts  are  secured 
by  banks  through  the  offer  of  lower  rates  of  interest 
than  those  paid  to  competing  banks  by  the  concerns 
sohcited.  Eastern  banking  institutions  have  been  able 
frequently  to  offer  the  western  borrower  lower  dis- 


154  BANK  CREDIT 

count  rates  than  prevailed  in  the  West  because  of  the 
greater  abundance  of  money  in  the  Eastern  banking 
centers.  Banks  in  New  York  City,  in  particular,  are 
said  to  resort  to  lower  rates  as  a  means  of  securing  new 
accounts,  except  in  periods  of  stringent  money. 

Again,  the  offer  of  a  more  extended  line  of  credit 
than  that  granted  by  rival  banks  has  been  used  as  a 
leverage  in  breaking  relations  already  estabhshed 
between  borrower  and  competing  bank.  A  house 
ha\dng  a  maximum  credit  of  $40,000  at  a  local  or  even 
metropohtan  bank  is  not  unlikely  to  be  receptive  with 
reference  to  an  offer  of  a  hne  of  credit  of  S50,000  com- 
ing through  the  new  business  department  of  another 
bank  whose  facihties  may  be  superior,  and  whose  name 
may  be  one  of  greater  prestige. 

Reference  need  scarcely  be  made  to  advertising  as 
a  means  of  obtaining  new  accounts.  Suffice  it  to  say 
that  in  recent  years  banks  have  advertised  in  the  dail}'- 
press,  monthly  and  other  periodicals,  trade  journals, 
bankers'  journals,  financial  pubhcations,  by  signs  in 
street  cars  and  even  by  bill  board  posters.  Books 
and  booklets,  blotters,  calendars,  and  cards  have 
been  distributed  with  a  freedom  that  would  have  scan- 
dahzed  bankers  of  the  old  school. 

Competition  among  commercial  banks  is  keen,  al- 
though not  unrestricted.  It  would  not  conform  with 
the  facts  to  say  that  the  new  business  department  sohcits 
accounts  wdthout  careful  discrimination  as  to  the  banks 
with  which  the  prospective  customers  already  have 
estabhshed  deahngs.  The  checks  of  possible  or  desir- 
able customers  passing  through  a  city  bank  bear  the 
names  of  the  respective  banks  with  which  customers 


RECENT  CHANGES  IN  CREDIT  ARRANGEMENTS  155 

do  their  banking  business  and  enable  the  city  banks  to 
pass  by,  as  if  undesirable,  the  customers  of  friendly 
institutions  and  to  seek  out  depositors  of  banks  for 
whose  goodwill  the  soliciting  bank  has  no  special  con- 
cern or  regard. 

The  activity  of  the  new  business  department, 
through  which  competition  finds  vent,  tends  to  place 
in  the  possession  of  each  borrower  whose  account  is 
sufficiently  important  to  attract  wide  attention,  a  line 
of  credit  in  keeping  with  the  decision  of  the  credit 
manager  and  lending  officer  whose  findings  and  judg- 
ment are,  of  all  the  soliciting  banks,  most  favorable  to 
the  borrower,  and  the  accounts  of  big  borrowers,  there- 
fore, tend  to  gravitate  toward  the  bank  with  a  liberal 
policy  of  credit  extension. 

The  work  of  the  bank  credit  department  in  appor- 
tioning available  banking  funds  among  the  most  pru- 
dent and  capable  borrowers  is  of  almost  incalculable 
social  value  and  the  new  business  department  extends 
the  field  to  which  the  beneficial  results  of  the  work  of 
the  credit  department  enure.  But  in  the  process  of 
extension,  as  we  have  just  seen,  there  arises  a  tendency 
to  grant  credit  more  freely  than  would  other  banks 
that  are  also  eagerly  striving  both  to  hold  old  accounts 
and  to  obtain  new.  Thus  the  constraining  and  conserv- 
ing influence  of  the  credit  department  of  one  bank  is 
qualified  and  impaired  by  the  activity  of  the  new  busi- 
ness department  of  another.  While  there  is  complete 
harmony  in  the  aims  and  work  of  the  two  departments 
in  an  individual  batik,  cross  purpose  appears  when 
they  are  viewed  from  the  standpoint  of  the  banks 
considered  as  a  system. 


156  BANK  CREDIT 

The  Influence  of  the  Federal  Reserve  System  upon  the 
Kind  and  Quality  of  Bank  Loans 

The  Federal  Reserve  system  also  has  had  a  marked 
influence  upon  the  kind  and  quality  of  our  bank  loans. 

The  estabhshment  of  the  system  has  had  a  strong 
tendency  to  increase  local  loans  with  a  corresponding 
reduction  in  the  volume  of  funds  placed  on  deposit  by 
banks  in  correspondent  banks.  Under  the  old  system  a 
manufacturer  desiring  to  buy  raw  material  to  be  fabri- 
cated into  goods  for  the  market  and  out  of  the  pro- 
ceeds of  their  sale  pay  off  his  loan  would  in  applying  for 
a  loan  for,  say,  ninety  days,  get  some  such  response  as: 
''We  would  like  to  make  you  the  loan,  you  have  always 
paid  your  obligations  promptly,  we  know  the  condi- 
tion of  your  enterprise  would  warrant  the  extension  of 
the  credit  you  desire.  But  we  are  sorry  that  our  own 
probable  needs  are  such  as  to  make  it  inexpedient  for 
us  to  make  the  loan  except  on  demand."  The  reply  of 
the  manufacturer  was:  "That  is  entirely  out  of  the 
question.  As  it  will  require  at  least  ninety  days  to 
place  the  goods  on  the  market,  a  demand  loan  might 
prove  very  embarrassing."  The  result  has  been  that 
the  manufacturer  has  not  taken  the  loan  and  produc- 
tion has  been  curtailed.  The  banker  probably  had  to 
be  satisfied  with  two  per  cent  paid  by  his  city  corre- 
spondent. 

Under  the  Federal  Reserve  system  with  its  facilities 
for  rediscount,  the  banker  can  feel  safe  in  lending, 
even  if  extraordinary  needs  loom  in  the  future.  Mak- 
ing a  loan  for  commercial  purposes  to  borrowers  of 
good  standing  no  longer  necessitates  the  tying  up  of 


RECENT  CHANGES  IN  CREDIT  ARRANGEMENTS  157 

funds  for  the  currency  of  the  loan.  Instead  of  lending 
to  his  correspondent  on  demand  at  two  per  cent,  the 
banker  may  now  lend  to  his  customers  at  a  higher  rate, 
but  with  as  great  freedom  from  apprehension  concern- 
ing the  future.  ^  It  is  easily  seen  that  this  circumstance, 
by  enlarging  the  power  of  banks  to  make  local  loans, 
and  by  curtailing  the  deposits  of  city  bankers,  must 
tend  to  relegate  the  call  loan  to  a  less  conspicuous  place 
in  our  financial  system.^ 

A  second  effect  worth  noting  is  that  in  certain 
quarters,  as  on  the  Pacific  Coast  and  in  the  St.  Louis 
district,  the  operation  of  the  Federal  Reserve  banks  has 
favored  the  discontinuance  of  the  practice  of  discount- 
ing paper  having  no  definite  maturity.  Years  ago, 
before  active  economic  development  commenced  on 
the  Pacific  Coast,  when  merchants  needed  Httle  ac- 
commodation, the  most  important  outlet  for  the 
bankers'  funds  was  to  loan  to  property  owners,  who 
were  naturally  encouraged  by  the  banks  to  keep  the 
funds  over  long  periods.  Under  these  conditions  it  was 
expedient  to  make  the  notes  payable  one  day  after 
date  with  the  understanding  that  the  notes  were  so 
drawn  in  order  to  enable  borrowers  to  pay  at  their 
convenience,  and  one-day  paper  in  California  means 
paper  with  an  indefinite  maturity.  Borrowers  still 
assume  that  they  may  pay  when  they  like,  while  bank- 
ers flatter  themselves  that  the  paper,  past  due,  is  sub- 

1  Cf.  W.  McC.  Martin,  Rediscount  Facilities  and  Methods,  Pro- 
ceedings, Nineteenth  Annual  Convention,  Indiana  Bankers'  Asso- 
ciation, 1915,  pp.  125,  126. 

^Cf.  Charles  S.  Hamlin,  Proceedings,  Nineteenth  Annual  Con- 
vention, Indiana  Bankers'  Association,  1915,  p.  118. 


158  BANK  CREDIT 

ject  to  call  on  demand.  Both  may  be  disappointed. 
The  growth  of  the  Federal  Reserve  system  in  magni- 
tude and  influence,  and  of  the  practice  of  rediscounting 
at  the  regional  banks,  must  tend  to  eliminate  paper  of 
the  kind  described  and  to  put  two  kinds  in  its  place: 
paper  that  is  payable  on  demand  with  collateral  back 
of  it  that  can  be  readily  sold  to  enforce  the  demand, 
and  paper  that  has  a  definite  maturity.^ 

A  third  effect  of  the  Federal  Reserve  system  has  been 
to  improve,  or  tend  to  improve,  the  quality  of  bank  loans 
through  the  requirement  that  paper  eligible  for  redis- 
count be  accompanied  by  a  statement  of  the  assets  and 
habiUties  of  the  borrower,  except  where  a  bank's  own 
depositor  borrows  not  more  than  S5,000  in  amount. 

The  introduction  of  the  trade  and  bank  acceptances, 
under  the  operation  of  the  Federal  Reserve  Act,  has 
also  worked  in  the  direction  of  sounder  and  more  liquid 
bank  loans. 

A  trade  acceptance  is  a  time  draft  drawn  by  a  seller 
of  goods  on  the  buyer  for  the  price  thereof,  and  bears  on 
its  face  the  signatm*e,  i.  e.,  acceptance,  of  the  buyer 
with  the  date  and  place  of  payment.  The  introduc- 
tion of  this  instrument  of  credit  into  many  hues  of 
trade  after  1913  has  given  the  banker  a  distinctly  Uquid 
portfolio  item.  Based  on  the  current  needs  of  the  ac- 
ceptor, this  two-name  paper  is  a  secondary  reserve  that 
can  be  converted  at  once  into  primary  reserve  through 
the  easy  process  of  rediscount.  Open  accounts  are 
looked  upon  by  many  bankers  as  "frozen." 

1  Stoddard  Jess,  Probable  Changes  in  Banking  Methods  under  the 
Federal  Reserve  Act,  Proceedings,  Twentieth  Convention,  California 
Bankers'  Association,  1914,  p.  96. 


RECENT  CHANGES  IN  CREDIT  ARRANGEMENTS  159 

A  bank  acceptance  differs  from  a  trade  acceptance 
in  that  the  bank  acceptance  is  executed  by  a  bank,  or 
other  corporation,  firm  or  person  engaged  in  the  busi- 
ness of  granting  acceptances.  Whatever  its  founda- 
tion, whether  domestic  or  foreign  trade,  the  bank 
acceptance  affords  a  superior  medium  for  investing 
bank  funds  which  are  to  be  held  hquid,  inasmuch  as 
such  paper  can  be  converted  into  cash  through  sale  in 
the  open  market  which  has  grown  up  since  1914  or 
through  rediscount  at  the  Federal  Reserve  or  other 
banks.  For  funds  only  temporarily  available,  the 
bank  acceptance  is  a  most  satisfactory  investment. 

The  revised  banking  law  of  New  York  State  con- 
ferred authority  upon  institutions  organized  under  its 
provisions  to  accept  for  payment  at  a  future  date 
drafts  drawn  upon  them  by  their  customers,  without 
Hmitation  as  to  the  nature  of  the  transactions  in- 
volved, and  numerous  houses  have  piu"suantly  be- 
come extensive  acceptors  and  dealers  in  bills.  With 
the  rise  of  these  institutions  national  and  other  banks 
have  adopted  an  increasingly  liberal  attitude  toward 
incurring  acceptance  obligations,  and  the  number  of 
banks  now  engaged  in  the  business  runs  well  into  the 
hundreds. 

In  the  open  market  for  bank  acceptances  the  Federal 
Reserve  banks  have  been  the  most  important  buyers, 
at  most  times  overshadowing  the  commercial  banks 
and  other  acceptors.  During  our  participation  in  the 
Great  War  and  for  a  short  time  previously  money 
rates  were  tight  and  bank  acceptances  would  have  been 
a  drug  on  the  market  but  for  the  hberal  acceptance 
buying  policy  of  the  regional  institutions.     In  the  er- 


i60  BANK  CREDIT 

ratic  market  following  the  cessation  of  hostilities  the 
same  banks  were  hea\'y  and  stabilizing  pm'chasers. 

The  growth  of  the  bank  acceptance  market  has  been 
little  short  of  phenomenal,  but  the  trade  acceptance 
has  had  a  hard  struggle  to  gain  recognition.  Commer- 
cial paper  houses  have  opposed  resort  to  the  trade 
acceptance  by  their  customers  on  the  valid  ground 
that  buying  banks  prefer  the  paper  of  concerns  whose 
borrowings  are  in  only  one  kind  of  paper.  Further- 
more, the  market  has  been  narrowed  by  the  unwilling- 
ness of  the  larger  banks  to  investigate  the  credit 
worth  of  houses  offering  trade  acceptances  when  the 
denominations  have  been  small.  The  development  of 
the  trade  acceptance  as  a  factor  in  our  open  market 
lies  chiefly  in  the  future. 


CHAPTER  VIII 
The  Bank  Borrower's  Statement: 

Assets 

The  credit  worth  of  a  borrower,  which  may  be 
defined  as  the  amount  which  he  will  be  able  and  willing 
to  repay  at  maturity  or  to  the  reasonable  satisfaction 
of  the  lender,  depends  upon  three  factors:  capital,^ 
business  ability  or  capacity,  and  character.  While, 
from  the  banker's  view  point,  capacity  and  character 
are  more  essential  than  capital  in  connection  with 
small  loans,  capital  more  or  less  liquid  is,  along  with  the 
other  two  factors,  a  sine  qua  non  in  connection  with 
loans  of  large  amount,  notably  loans  to  corporations, 
in  which  the  element  of  personal  responsibility  is,  in 
comparison  with  loans  to  firms  and  individuals,  some- 
what less  conspicuous. 

Reference  was  made  in  the  last  chapter  to  the 
growing  custom  of  banks  in  requiring  borrowers  and 
those  desiring  to  borrow  to  submit  statements  consist- 
ing, generally,  of  a  balance  sheet  and,  frequently,  an 
income  account,  as  a  means  of  enabling  the  banker 
to  pass  intelligently  upon  loan  applications.  It  will  be 
our  purpose  now  to  examine  the  borrower's  statement 
as  an  index  of  his  credit  worth.    That  statement  will 

1  Collateral,  which  is  frequently  the  most  important  criterion  of  a 
borrower's  credit  worth,  is  discussed  in  chapter  XII,  on  secured 
loans. 

161 


162  BANK  CREDIT 

be  studied  with  a  view  to  discover  what  light  it  throws 
on  the  borrower's  capital  and  capacity.  From  the 
borrower's  statement  experienced  credit  men  are  able 
incidentally  to  make  important  deductions  bearing 
upon  his  character.  Information  concerning  the  char- 
acter of  the  borrower,  however,  is  for  the  most  part 
obtained  from  sources  extraneous  to  the  statement. 

In  the  analysis  of  a  borrower's  statement  the  bank 
credit  man  has  uppermost  in  his  mind  two  questions. 
First,  is  there  a  reasonable  certainty  that  the  proposed 
loan  will  be  met  at  maturity,  and,  second,  if  unfore- 
seen circumstances  should  prevent  payment  at  matu- 
rity will  the  loan  be  paid  ultimately?  An  answer  to  the 
first  and  most  important  question  is  sought  largely  in 
the  relation  of  the  borrower's  quick  assets  to  his  cur- 
rent liabilities;  an  answer  to  the  second,  in  the  rela- 
tion of  his  slow  or  permanent  assets  to  his  permanent 
liabilities.  At  the  very  outset,  then,  the  banker  divides 
both  the  assets  and  habilities  into  quick  or  current 
and  slow  or  permanent.^  Current  liabilities  must  be 
met  out  of  quick  assets;  permanent  habilities  should  be 
fully  offset  by  slow  or  permanent  assets. 

The  form  of  statement  that  banks  ask  their  bor- 
rowers to  sign  varies  decidedly.-    It  will  be  advisable 

1  Clay  Herrick,  Borrowers'  Statements  and  the  Rulings  of  the 
Federal  Reserve  Board,  25th  Annual  Convention,  Ohio  Bankers' 
Association,  1915,  p.  45. 

2  Appendix  B,  containing  the  report  of  the  committee  on  credit 
forms  made  to  the  American  Bankers'  Association,  at  Atlantic 
City,  N.  J.,  September  28,  1917,  gives  forms  designed  for  (1)  farmer, 
(2)  finn  or  individual  (manufactm-er  or  merchant),  (3)  corporation 
(manufacturer  or  merchant) .  By  no  means  all  borrowers  consent  to 
fill  out  forms,  particularly  those  furnished  by  the  banker.    Many 


THE  BANK   BORROWER'S  STATEMENT  163 

here  to  present  a  statement  for  study  with  all  but  its 
most  essential  features  pared  away. 

Assets 

Cash  on  hand $ 

Cash  in  bank 

Accounts  and  notes  receivable 

Merchandise: 

Finished $ 

In  process 

Raw  material 

Real  Estate 

Machinery  and  fixtures 

Other  Assets,  and  of  what  composed 

Total  Assets $ 


Liabilities 

Bills  payable  for  merchandise 

Accounts  payable 

Bills  payable  to  own  bank 

Bills  payable  for  paper  sold 

Mortgages  on  real  estate 

Chattel  mortgages 

Bonded  debt 

Deposits  of  money  with  us 

Other  indebtedness,  and  of  what  composed . 


Net  worth  or,  in  case  of  corporation,  the  capital  stock  plus 
surplus  or  minus  deficit 


corporations  insist  on  ignoring  such  forms  and  in  their  place  give 
their  own  formulated  statement. 


164  BANK  CREDIT 

Questions  are  inserted,  following  this  statement, 
concerning  contingent  liabilities,  insurance,  deprecia- 
tion, total  sales  for  pre\'ious  year,  terms  of  sale,  an- 
nual expenses,  dividends,  etc. 

Obviously  the  most  Hquid  asset  of  a  business  enter- 
prise must  be  its  cash.  Next  are  accounts  and  notes 
of  customers,  which  are  only  a  step  removed  from  cash 
in  the  degree  of  their  liquidity.  Such  receivables  con- 
stitute the  connection  between  merchandise  or  manu- 
factured product  on  the  one  hand  and  cash  on  the 
other.  Merchandise  or  manufactured  product,  flow- 
ing in  a  constantly  changing  stream,  is  transformed 
into  notes  and  accounts  receivable  and,  with  the  prog- 
ress of  time,  the  receivables  are  merged  one  by  one 
into  cash.  Merchandise  or  finished  product,  receiv- 
ables, cash,  are  the  principal  quick  or  liquid  assets. 

The  difference  between  quick  and  slow  assets  may 
be  not  only  a  difference  in  degree  but  also  one  of  kind. 
The  value  and  quick  salability  of  many  quick  assets, 
e.  g.,  merchandise,  depends  upon  the  consuming  power 
of  the  community  or  market.  The  value  of  other  quick 
assets,  e.  g.,  United  States  bonds,  has  little  or  no  rela- 
tion to  the  consuming  power  of  the  community  at  the 
time.  The  value  of  slow  or  fixed  assets,  such  as  real 
estate,  plant  and  machinery,  depends  largely  upon 
their  present  and  prospective  earning  power. 

Current  liabilities  consist  of  accounts  and  notes 
payable,  wages,  interest  and  other  items  of  a  current 
nature.  Slow  or  permanent  liabilities  include  chiefly 
such  long  time  obligations  as  bonded  indebtedness, 
mortgages  or  liens  on  real  estate  and  plant,  and  ''de- 
posits of  money  with  us."     The  last  named  may,  in 


THE  BANK  BORROWER'S  STATEMENT         165 

many  instances,  be  more  properly  treated  as  a  current 
obligation. 

The  capital  of  the  borrower,  by  which  is  meant 
the  proprietors'  interest  in  the  case  of  a  partnership 
and  the  net  worth  in  the  case  of  an  individual  entre- 
preneur, is  equal  to  the  assets  minus  the  liabilities. 
When  a  corporation  is  concerned  the  capital,  as  we  are 
using  the  term,  is  equal  to  the  par  value  of  the  capital 
stock  plus  the  surplus  or  minus  the  deficit.  But  deduc- 
ing the  amount  of  the  borrower's  assets  available  for 
the  pajTnent  of  current  debts,  as  well  as  ascertaining 
the  aggregate  capital,  is  more  than  a  matter  of  mere 
arithmetic;  careful  scrutiny  of  the  balance  sheet  is  re- 
quired, item  by  item. 

Cash  on  Hand  and  in  Banks 

Cash  on  hand  and  in  banks  should  be  large  enough 
properly  to  "balance"  the  statement.  The  most  ap- 
proved amount  varies  wdth  the  requirements  of  differ- 
ent lines  of  business,  but,  in  general,  bankers  like  to  see 
from  5  to  15  per  cent  of  the  quick  assets  in  the  form  of 
cash.  If  the  cash  is  very  small  the  concern  is  in  danger 
of  being  unable  to  meet  maturing  obligations  in  the 
event  of  a  falling  off  in  expected  collections.  An  in- 
adequate balance  will,  at  the  same  time,  tend  to  cause 
the  banker  to  be  indisposed  to  extend  needed  credit. 
If  the  cash  is  disproportionately  large  the  borrower  is 
impairing  his  ability  to  meet  future  obligations  by  not 
keeping  at  work  money  on  which  he  may  be  paying 
interest.  The  shrewd  and  far-seeing  borrower  will  re- 
duce the  cash  item  in  fair  weather  and  increase  it  in 
advance  of  the  storm.    The  concern  with  plentiful  cash 


166  BANK  CREDIT 

on  hand  in  time  of  monetary  stringency  or  crisis  has 
an  enviable  purchasing  position.^ 

The  credit  man  considers  cash  on  hand  and  in  bank 
from  two  angles,  quality  and  quantity.  In  quality  the 
item  is  likely  to  be  adulterated.  Besides  the  legitimate 
currency,  checks,  and  bank  deposits,  there  may  be 
found  floating  memoranda  of  varying  degrees  of  mag- 
nitude and  character.  A  controlling  officer  may  be 
liberally  represented  in  the  cash  drawer  by  his  I.  0. 
U.'s.2  A  worthless  check  of  a  partner  may  be  kept  in 
the  cash  drawer  over  statement  day,  later  to  be  de- 
stroyed.^ 

A  large  number  of  I.  0.  U.'s  or  other  slips  of  paper 
representing  cash  is  sometimes  found  traceable  to  the 
use  of  what  is  knowm  as  the  imprest  cash  system,  by 
which  the  cashier  in  branch  office  or  factory  is  given 
a  fixed  working  fund  out  of  which  to  make  payinents 
from  time  to  time,  it  being  understood  that  the  sum  of 
the  expense  vouchers  plus  the  cash  on  hand  is  at  all 
times  to  be  equal  to  this  cash  fund.  These  funds  are 
commonly  reported  at  the  full  amount  although  a  con- 
siderable portion  of  the  cash  recorded  may  be  in  the 
form  of  vouchers  which  are  later  to  be  charged  to  ex- 
pense or  capital  accounts. 

Cash  has  been  known  to  be  tied  up  in  failed  banks, 

1  Norman  I.  Adams,  Credit  Department,  Analysis  of  the  Financial 
Statement,  a  lecture  delivered  before  the  Boston  Chapter  of  the 
American  Institute  of  Banking,  February  4,  1913,  pp.  5,  6. 

2  Frederick  H.  Hurdman,  Credits  from  the  Stand-point  of  the  Cer- 
tified Public  Accountant,  Proceedings,  Fortieth  Annual  Convention, 
American  Bankers'  Association,  1914,  pp.  468,  469. 

»  Norman  I.  Adams,  op,  cit.,  p.  5. 


THE  BANK  BORROWER'S  STATEMENT         167 

and  to  have  been  stolen  by  employees.  Cash  on  de- 
posit at  the  bank  may  be  tied  up  by  liens  against  it,  or 
may  be  in  the  form  of  a  special  deposit  which  is  not  to 
be  withdrawn  except  after  a  time  notice.  Cash  on 
hand  at  the  date  of  the  statement  has  been  known  to 
disappear  the  next  day  through  dividend  or  other  spe- 
cial disbursements.^  While  cash  on  hand  is  a  question- 
able asset,  being  so  easily  transferred  from  one  pocket 
to  another,  cash  in  bank  is  subject  to  easy  verification 
where  the  borrower  is  a  depositor  of  the  lending  bank, 
and  must  be  carefully  analyzed  in  the  light  of  a  knowl- 
edge of  market  conditions  in  the  trade  of  the  borrower. 
Some  trades  have  only  one  season;  some  have  two; 
others  have  four.  In  the  first  case  the  borrower  will 
have  a  flush  season  when  a  large  bank  balance  will  be 
carried  followed  by  a  season  when  such  balance  will  be 
at  a  minimum,  and  when  heavy  borrowing  will  be 
necessary.  Where  a  concern  has  two  seasons  and  even 
more  emphatically  when  it  has  four  seasons,  i.  e.,  a 
continuous  market,  its  receipts  should  approximate  its 
outgo  and  then  a  bank  balance  disproportionately 
small  with  reference  to  obligations  would  be  an  ele- 
ment of  weakness.-  The  shrewd  lender  does  not  fail  to 
ascertain  whether  cash  has  been  ''rigged"  through  the 
accumulation  of  receipts  and  the  postponement  of 
expenditures. 

For  the  sake  of  the  good  will  of  his  banker  a  borrower 

1  Clay  Herrick,  Borrowing  Statements  and  the  Rulings  of  the  Federal 
Reserve  Board,  Proceedings,  Twenty-I'ifth  Annual  Convention,  Ohio 
Bankers'  Association,  1915,  p.  48. 

^  W.  Oliver  Craig,  Banking  Credits,  Bulletin,  American  Institute 
of  Bank  Clerks,  Vol.  V,  p.  709. 


168  BANK  CREDIT 

should  maintain  an  average  balance  equal  to  at  least 
20  or  25  per  cent  of  the  loans  extended.  Such  a  balance 
is  justifiable  on  the  ground  that  the  bank  itseK  keeps 
balances  in  numerous  and  widely  scattered  banks  as 
compensation  for  clearing  and  collecting  items  within 
their  territory.  Even  the  largest  banks  with  the  most 
modem  facihties  use  other  banks  as  agents  in  making 
collections. 

Where  the  borrower  maintains  that  he  has  only  one 
bank  account,  it  is  a  good  practice  for  the  banker  to 
compare  the  amount  of  cash  in  bank  shown  in  the 
statement  with  the  bank's  records,  as  a  check  on  the 
borrower's  figures.  Although  the  two  amounts  will  not 
agree  exactly  on  account  of  outstanding  checks,  any 
gross  overstatement  may  be  detected. 

A  bank's  records  are  of  value  also  in  throwing  Ught 
on  the  cash  item  at  times  other  than  on  statement 
dates.  Banks  sometimes  examine  a  borrower's  deposit 
account  in  order  to  ascertain  whether  his  balance 
would  have  been  overdrawn  had  all  checks  outstanding 
on  a  given  date  been  presented  for  pajrment  on  that 
date.  An  account  potentially  overdrawn  is  a  sign  of 
financial  strain  which  the  banker  justly  views  with 
misgiving  and  concern. 

In  very  few  instances  should  a  large  sum  of  money 
appear  under  the  head  of  cash  on  hand.  If  this  item 
is  large,  it  is  very  likely  to  be  a  sign  of  lax  financial 
methods.  Few  businesses  in  the  twentieth  century 
require  that  any  large  amounts  be  paid  out  in  actual 
cmTency.  Even  wages — although  the  practice  is 
not  always  socially  and  economically  desuable — are 
usually  paid  by   check.     The  careful  business  man 


THE  BANK  BORROWER'S  STATEMENT         169 

makes  it  a  rule  to  bank  all  cash  as  it  is  received.  The 
man  who  does  otherwise  is  likely  to  be  careless  about 
other  and  more  vital  features  of  his  business.^ 

Accounts  and  Notes  Receivable 

Notes  receivable,  once  an  important  item  in  the 
balance  sheet  of  American  business  enterprises,  have 
almost  entirely  given  way  to  open  accounts.  Only  in 
such  businesses  as  the  lumber,  some  branches  of 
the  tobacco  business,  the  jewelry  and  piano  trades, 
plumbers'  supphes,  and  agricultural  implements,  does 
the  note  persist.  The  appearance  of  notes  receivable 
in  the  statements  of  concerns  engaged  in  other  lines  is 
almost  certain  evidence  that  such  obligations  repre- 
sent a  conversion  of  slow  and  perhaps  uncollectable 
outstanding  accounts. 

Taken  together  these  two  items,  notes  and  accounts 
receivable,  should  bear  a  definite  and  fairly  constant 
relation  to  the  volume  of  sales,  and  violent  fluctuation 
above  or  below  the  percentage  as  calculated  on  state- 
ments rendered  by  successful  concerns  in  the  same  line 
of  trade  or  manufacture  as  well  as  on  'the  last  state- 
ment submitted  by  the  borrower  should  evoke  the 
banker's  closest  scrutiny  as  indicating  one  or  more  of 
three  conditions.^ 

In  the  first  place  trade  conditions  may  be  abnormal. 
The  extent  to  which  an  increase  in  the  ratio  of  re- 
ceivables to  sales  is  due  to  this  cause  can  generally  be 
satisfactorily    determined    by    the    banker    from    his 

1  Ernest  Reckitt,  Commercial  Balance  Sheets,  Bulletin,  American 
Institute  of  Banking,  Vol.  XI,  p.  537. 

2  Idem,  op.  cit.,  p.  538. 


170  BANK  CREDIT 

knowledge  of  trade  and  financial  conditions.  Any 
reasonable  banker  would  expect  an  increase  in  the  ratio 
of  receivables  to  sales  during  a  crisis. 

In  the  second  place  there  may  have  been  a  falling  off 
in  the  efficiency  of  the  credit  and  collection  depart- 
ments of  the  business  of  the  borrower  and  more  exten- 
sive credit  may  have  been  extended  to  customers  than 
formerly.  Close  inquiry'  as  to  the  workings  of  the 
credit  department  of  the  borrower  frequently  throws 
strong  light  on  the  liquidness  of  receivables.  When- 
ever a  thoroughly  capable  credit  man  is  in  charge  of 
the  credit  department  of  the  borrower's  business  it  is 
not  only  insurance  against  wide  fluctuation  in  the 
relation  of  receivables  to  sales  but  is  also  a  presump- 
tive indication  of  worth  in  the  receivables  of  the  con- 
cern. 

In  the  third  place  a  marked  rise  in  the  ratio  may 
indicate  that  the  figures  for  either  sales  or  receivables 
or  both  have  been  manipulated.  If  this  supposition 
arises  the  banker  would  naturally  be  wary  about 
extending  credit.  He  may  well  insist  that  competent 
accountants  and  appraisers  examine  the  affairs  of  the 
borrower  in  detail. 

Book  accounts,  like  notes  receivable,  are  seldom  if 
ever  worth  par  despite  a  strong  incUnation  among 
borrowers  so  to  regard  them.  The  foremost  question 
that  the  banker  has  to  ask  in  connection  with  this  item 
has  to  do  with  the  allowance  for  bad  debts.  In  addition 
the  banker  ought  to  know  to  what  extent,  if  any,  per- 
sonal accounts  of  officers  or  employees  are  included. 
Is  the  business  national  in  scope  and  are  the  accounts 
widely  distributed  geographically  so  as  to  avoid  the 


THE  BANK  BORROWER'S  STATEMENT         171 

likelihood  of  having  the  bulk  of  them  in  territory  where 
business  is  depressed?  A  concern  whose  accounts 
were  mainly  in  the  cotton  states  in  the  fall  of  1914 
was  in  an  unenviable  position.  To  what  extent  are 
accounts  in  the  hands  of  attorneys  for  collection? 
What  is  the  volume  of  assignment  accounts?  Have 
any  accounts  been  sold  to  discount  companies  that 
have  presumably  taken  off  the  cream?  Do  any  of  the 
accounts  represent  amounts  due  from  branches  or 
affiliated  concerns?  All  these  questions  are  calculated 
to  enlighten  the  banker  as  to  essential  facts  in  con- 
nection with  this  important  item.^ 

Occasionally  statements  show  accounts  and  notes 
receivable  under  and  over  sixty  days  due.  As  a  general 
rule  this  does  not  explain  how  the  accounts  receivable 
stand,  as  there  may  be  bad  accounts  not  yet  long  over- 
due and  large  items  long  overdue  that  are  fully  guaran- 
teed. To  the  banker  who  can  count  upon  the  veracity 
and  honesty  of  the  borrower  a  statement  that  shows 
the  accounts  that  are  good  would  mean  more  than  one 
that  distinguished  between  those  over  and  those  under 
sixty  days  due.^ 

The  element  of  uncertainty  in  notes  receivable  is 
more  pronounced  than  in  accounts  receivable.  Per- 
haps some  notes  have  been  renewed,  and  others  may 

1  Clay  Herrick,  Borrowers'  Statements  and  the  Rulings  of  the  Federal 
Reserve  Board,  Twenty-Fiftli  Annual  Convention,  Ohio  Bankers' 
Association,  1915,  p.  49.  Also  cf.  Thomas  J.  Kavanaugh,  Essentials 
in  the  Granting  of  Bank  Credits,  Trust  Companies,  Vol.  XXIII, 
No.  2,  August,  1916,  p.  120. 

2  William  Whitfield,  Actual  Conditions  versus  Borrowers'  State- 
ments, Proceedings,  Oregon  State  Bankers'  Association,  1914,  p.  43. 


172  BANK  CREDIT 

be  past  due.  Let  the  credit  man  ascertain  whether  all 
the  notes  have  arisen  from  the  regular  course  of  busi- 
ness. Some  may  represent  loans  to  officers  or  employees 
or  other  indi\'iduals.  In  corporations,  shareholders 
sometimes  give  notes  in  payment  of  capital  stock. 
Notes  of  subsidiary  concerns  may  be  among  others. 
In  many  lines  of  business  only  the  less  desirable  cus- 
tomers give  notes,  others  buying  on  open  account  or 
for  cash.  A  large  amount  of  notes  receivable  appear- 
ing in  a  statement  submitted  to  a  banker  would  in 
most  Unes  of  trade  indicate  that  the  borrower  was 
dealing  with  weak  concerns  that  were  not  able  to  dis- 
count their  bills.  In  some  businesses,  e.  g.,  the  piano 
business,  receivables  are  likely  to  contain  notes  payable 
in  monthly  instalments,  and  extending  over  a  long 
period.^  It  is  only  after  taking  such  matters  as  these 
into  consideration  that  a  banker  can  estimate  with 
a  satisfactory  degree  of  accuracy  whether  this  item  in 
the  balance  sheet  represents  quick  assets  on  which  he 
can  rely.  "WTien  notes  receivable  are  found  it  is  always 
important,  as  already  indicated,  for  the  banker  to 
ascertain  whether  they  are  in  the  possession  of  the  bor- 
rower and  not  hypothecated. 

The  note,  as  compared  wdth  the  book  account,  is 
objectionable  from  the  standpoint  of  both  bank  and 
borrower  because  of  the  difficulty  of  taking  quick  legal 
action  for  recoveiy,  should  doubt  arise  as  to  the  sol- 
vency of  the  signer.  If  a  note  is  taken  for  three  months 
and  in  the  meantime  doubt  arises  as  to  the  solvency  of 
the  maker,  quick  action  for  recovery  is  impracticable. 
Effective  legal  action  cannot  be  taken  until  the  note 
1  Clay  Herrick,  op.  cit.,  pp.  48,  49. 


THE  BANK  BORROWER'S  STATEMENT         173 

matures.  In  the  case  of  an  open  account,  on  the  other 
hand,  the  legal  means  of  recovery  are  quickly  avail- 
able. ^ 

Where  the  banker  is  distrustful  of  the  items  of 
accounts  and  notes  or  bills  receivable,  his  suspicions 
may  be  confirmed  or  removed  by  obtaining  an  itemized 
list  and  establishing  the  worth  of  each  separate  ac- 
count. 

Merchandise  or  Inventory 

It  must  be  said  at  the  outset  that  this  item  fre- 
quently gives  no  end  of  trouble  to  the  credit  man  of 
the  bank.  "Inventory  is  the  acid  test  of  honesty." 
The  audit  of  certified  accountants  frequently  throws 
only  a  dim  light  on  the  character  and  actual  value  of 
the  stock  of  goods,— so  easy  is  it  for  a  concern  here  to 
conceal  its  actual  condition.  As  it  is  difficult  for  the 
accountant  to  take  complete  inventories  in  many 
large  establishments,  an  official  simply  certifies  to 
the  correctness  of  the  figures.  It  is  true  that  account- 
ants frequently  sample  the  inventory,  making  such 
physical  tests  as  practicable,  but  old  and  shopworn 
goods  or  those  that  have  lost  much  of  their  original 
salability  on  account  of  being  out  of  date  cause  ac- 
countants a  great  deal  of  difficulty  of  appraisal.  Lines 
very  difficult  to  appraise  accurately  are  women's 
wearing  apparel,  millinery,  novelties  and  those  in 
which  the  style  element  is  prominent. 

More  and  more  frequently  banks  extending  heavy 
lines  of  credit  are  having  their  own  representatives 

1  William  Post,  Analysis  of  Borrowers'  Statements,  Journal  of 
Accountancy,  January,  1906,  Vol.  I,  No.  3,  p.  183. 


174  BANK  CREDIT 

from  the  credit  department,  after  becoming  thoroughly 
familiar  -^ath  the  stock  of  merchandise  composing  the 
inventory,  not  only  audit  the  books  of  the  borrower 
but  make  a  careful  appraisal  of  assets  as  well.  In 
many  cases  an  acquaintance  in  the  trade  can  be  rehed 
upon,  particularly  by  bankers  in  the  smaller  cities,  for 
expert  opinion  with  reference  to  the  valuation  set  forth 
in  the  statement.  Experts  in  the  trade  would  be 
familiar  with  the  value  of  both  finished  and  unfinished 
goods. 

When  accountants  and  special  appraisers  are  re- 
sponsible for  auditing  a  concern's  affairs  it  is  always 
advisable  to  have  the  audit  follow  closely  on  the  heels 
of  the  annual  inventory  as  this  procedure  affords  the 
auditors  better  opportunity  to  make  physical  tests  of 
the  inventory  as  a  check  on  the  inventory  figures  fur- 
nished by  the  concern.^ 

The  location  of  the  goods  inventoried  is  not  a  neg- 
ligible factor  to  the  credit  man  analyzing  the  state- 
ment. Goods  scattered  in  mmaerous  agencies  or 
branches  not  only  require  a  superior  organization  at  the 
main  office  for  administrative  purposes  but  also  more 
than  ordinary  care  and  \'igilance  in  evaluation.^  If 
distributed  in  warehouses,  branch  offices  or  sales 
agencies,  merchandise  or  supphes  are  accounted  for  less 
simply  and  accurately  than  when  kept  in  one  center. 

^  Charles  E.  Meek,  Proceedings,  Twenty  Second  Annual  Meeting, 
Kentucky  Bankers'  Association,  1914,  p.  55,  and  Financial  Age, 
October  3,  1914. 

2  William  Post,  The  Four  Big  C's,  Address  delivered  at  the  Meet- 
ing of  the  Philadelphia  Credit  Men's  Association,  January,  1910, 
pp.  48,  49. 


THE  BANK  BORROWER'S  STATEMENT         175 

The  location  of  goods  inventoried,  is,  however,  of 
much  less  interest  and  import  to  the  banker  than  the 
method  of  valuation.  Inventories  will  frequently  vary 
in  the  ratio  of  1  to  6,  according  to  the  basis  or  method 
of  valuation,  and  allowance  for  obsolete,  deteriorated 
or  second-hand  stock.  A  given  stock  may  be  inven- 
toried at  as  low  a  figure  as  $25,000  or  as  high  as 
$150,000.  How  the  inventory  item  may  mislead  the 
unwary  banker,  owing  to  a  defective  basis  of  appraisal, 
will  be  made  plain  by  an  illustration.  In  the  case  of 
concerns  dealing  in  equipment,  machines,  etc.,  it  may 
be  necessary  to  take  in  second-hand  stock  in  exchange 
for  new  machines,  etc.,  sold.  The  second-hand  goods 
may  be  put  on  the  books  at  their  ''trade-in"  value, 
which  may  greatly  exceed  their  selling  value.  The 
relative  inventory^  may  be  taken  from  the  office  rec- 
ords and  the  banker  be  misled  when  he  examines  the 
balance  sheet  accompanying  an  application  for  a  loan.^ 
An  auditing  accountant  would  be  able  in  a  situation  of 
this  kind  to  discover  the  overvaluation  and  would 
probably  make  such  arbitrary  reduction  as  he  thought 
fitting;  but  auditing  and  appraisal  representatives  of 
the  bank,  by  reason  of  specialized  knowledge,  would 
likely  succeed  in  making  the  reduction  more  nearly  in 
accord  with  the  facts. 

Although  there  is  some  difference  of  opinion  among 
credit  men  as  to  the  point,  the  basis  of  merchandise 
valuation,  it  is  pretty  generally  agreed,  should  be 
either  cost  or  market  price,  whichever  is  lower.  All 
old  and  unmarketable  goods  should  be  written  off  the 

*  William  Whitfield,  Actual  Conditions  versus  Borrowers'  State- 
ment, Proceedings,  Oregon  State  Bankers'  Association,  1914,  p.  44. 


176  BANK  CREDIT 

inventory.  During  a  period  of  rapidly  rising  prices, 
on  the  other  hand,  cost  of  replacement  may  justifiably 
be  made  the  basis  of  inventory  appraisal.  Fire  in- 
surance conditions  on  occasion  may  even  make  this 
procedure  imperative.^ 

The  banker  ought  to  guard  against  the  occasional 
and  obviously  objectionable  practice  of  taking  mer- 
chandise into  the  inventory^  without  immediately  enter- 
ing the  bills  upon  the  books  as  a  Habihty.  He  ought 
also  to  insist  that  there  be  no  omission  from  the  inven- 
tory of  stock  taken  into  the  house,  even  though  the 
relative  habiUties  are  also  omitted  from  the  statement. 
To  leave  out  both  goods  and  the  habilities  therefor, 
which  results  in  showing  upon  the  statement  small 
stocks  and  reduced  liabiUties,  distorts  favorably  to  the 
borrower  the  ratio  of  quick  assets  to  current  liabilities. 
To  make  this  clear  let  us  suppose  a  given  borrowing 
customer  of  a  bank  ti-uthfully  states  his  quick  assets  as 
worth  $500,000  and  his  current  liabilities,  including  the 
amount  of  the  loan  required,  $300,000.  The  ratio  is 
5  to  3  and  such,  perhaps,  as  to  raise  serious  question  in 
the  mind  of  the  banker  as  to  the  wdsdom  of  lending. 
Now  let  the  applicant  for  the  loan  omit  from  his  state- 
ment $100,000  worth  of  merchandise  just  put  in  stock 
and  the  same  amoimt  from  his  current  habilities  and 
the  ratio  becomes  $400,000  to  $200,000  or  2  to  1.  The 
double  omission  is  most  common  in  Unes  of  business 
handling  seasonal  goods  where  the  purchasers  of  one 
season  are  designedly  separated  on  the  books  of  the 
concern  from  the  purchases  of  another.     Convenient, 

1  J.  H.  Tregore,  Journal  of  Commerce,  February  10,  1917. 


THE  BANK  BORROWER'S  STATEMENT  "       177 

perhaps,  to  the  borrower,  the  practice  is  fraught  with 
deception  to  the  banker.^ 

Statements  of  manufacturing  concerns  should  class- 
ify stock  as  among  raw  materials,  goods  in  process,  and 
finished  products.  Raw  materials  and  suppHes^  like 
cotton,  wool,  metals,  fuel,  and  oil,  are  commonly 
so  salable  that  they  may  be  safely  appraised  at  cost. 
When  finished  goods  have  a  ready  market  they  are 
conservatively  inventoried  at  cost,  but  ''cost,"  it  is 
obvious,  should  not  include  any  expenses  involved  in 
the  sale  of  the  goods.  Some  bankers  insist  that  goods 
in  process  be  valued  at  cost  of  raw  materials  and  some 
have  no  objection  to  a  valuation  according  to  the  fig- 
ures contained  in  cost  sheets.  The  last  mentioned 
practice  is  unobjectionable  to  the  extent  that  the  bor- 
rower is  solvent  and  prosperous  beyond  question. 
However,  the  credit  man  must  always  face  the  fact 
that  unfinished  goods  require,  in  the  event  of  failure, 
heavy  expenditures  under  unfavorable  conditions  pre- 
paratory to  marketing. 

One  of  the  principal  points  in  the  investigation  made 
by  the  credit  department  is  to  ascertain  how  a  concern 
buys  its  goods,  whether  the  buyer  or  buyers  are  com- 
petent to  judge  merchandise  or  materials  and  disposed 
to  buy  in  accordance  with  requirements.     No  one 

1  C/.  Frederick  H.  Hurdman,  op.  cit.,  p.  473. 

2  It  is  in  place  to  point  out  that  a  large  amount  of  raw  material 
represented  in  the  balance  sheet  of  a  manufacturing  concern  may 
well  indicate  that  the  concern  is  buying  heavily  when  prices  are 
low, — a  ch-cumstance  that  may  promise  large  profit  without  great 
risk  of  loss,  during  a  period  of  rising  prices.  Cf.  Louis  N.  Roe,  The 
Granting  of  Credit,  Bankers'  Magazine  (New  York),  Vol.  LXXXIII, 
Nov.  1911,  p.  604. 


178  BANK  CREDIT 

knows  better  than  the  experienced  lending  officer  of  a 
bank  how  seriously  injudicious  buying  and  the  accum- 
ulation of  undesirable  stock  will  impair  the  resources 
of  a  concern.  "Goods  well  bought  are  half  sold." 
Shrewd  buying  has  its  reflection  in  a  clean  and  salable 
inventory. 

It  would  be  a  mistake  for  the  reader  to  suppose 
that  general  rules  exist  for  the  valuation  of  merchan- 
dise or  other  assets.  Nothing  could  be  more  erroneous. 
The  credit  man  or  lending  officer  of  the  bank  considers 
each  case  on  its  own  merits.^  Even  in  the  case  of  such 
staples  as  flour,  iron,  leather,  wool  and  cotton  different 
grades  exist  and  only  an  approximation  to  a  correct 
valuation  is  possible,  albeit  daily  quotations  furnish  a 
record  of  the  market  values.  Whether  in  times  of 
peace  or  war  wide  fluctuations  occur  in  the  value  of 
such  necessaries  as  those  mentioned,  within  a  relatively 
short  time.  The  sagacious  lending  officer  not  only 
makes  allowance  for  such  fluctuation  but  also  leans 
heavily  upon  the  judgment  of  trade  experts. 

Should  the  lending  banker  become  involved  in  the 
affairs  of  a  concern  whose  assets  are  largely  in  mer- 
chandise he  ought  to  bear  clearly  in  mind  that  the  sale 
of  a  stock  of  merchandise  at  prices  that  will  cause  any- 
thing short  of  a  slaughter  of  the  interests  of  the  mer- 
chant or  banker,  where  he  is  concerned,  requires  con- 
siderable time.  The  failure  of  a  merchant  to  pay 
100  cents  may  be  due  in  large  measure  to  bankers 
clamoring  for  a  settlement,  and  forcing  a  quick  sale  of 
goods  in  bulk.    A  merchant  in  Philadelphia  in  partner- 

1  William  Post,  Analysis  of  Borrowers'  Statements,  Journal  of 
Accountancy,  Vol.  I,  No.  3,  January,  1906,  p.  186. 


THE  BANK  BORROWER'S  STATEMENT         179 

ship  with  another  bought  the  stock  of  a  bankrupt 
concern  in  Boston  and  cleared  one  hundred  thousand 
dollars  in  ten  months.  The  creditors  were  banks 
impatient  for  a  settlement.  They  got  it,  ''reasonably 
quick  and  unreasonably  small." ^ 

Real  Estate,  Machinery  and  Equipment 

The  statement  should  give  full  information  concern- 
ing land,  buildings  and  equipment,  including  a  de- 
scription, along  with  data  covering  any  indebtedness 
against  the  property  in  the  nature  of  mortgages  or 
other  liens.  The  apparent  equity  of  a  concern  in  mort- 
gaged real  estate  may  be  seriously  reduced  by  back 
taxes,  assessments  and  other  liens  of  this  character. 
The  valuation  of  property  should  be  compared  with  the 
county  (or  other)  assessment  figures,  and,  wherever 
practicable,  the  mortgage  records  investigated. 

In  securing  a  statement  from  an  individual  borrower 
the  cautious  banker  is  careful  to  have  it  explicitly 
stated  that  the  real  estate  is  held  in  the  name  of  the 
borrower,  and  not  jointly.  Even  borrowers  of  honesty 
and  integrity  have  a  habit  of  forgetting  to  mention 
that  realty  is  held  jointly  with  their  wives.  This  is  a 
point  where  state  laws  seem  to  favor  the  debtor.  ^ 

It  is  contended  in  some  quarters  that  the  credit 
man's  valuation  of  the  real  estate  item  should  be  in- 
fluenced by  such  a  factor  as  how  essential  the  real 
estate  is  to  the  profitable  conduct  of  the  business  of 

1  William  Post,  The  Credit  and  Loan  Department,  Bulletin, 
American  Institute  of  Bank  Clerks,  Vol.  Ill,  p.  136. 

2  J.  H.  Johnson,  Proceedings,  Thirteenth  Annual  Convention, 
Michigan  Bankers'  Association,  1901,  p.  43. 


180  BANK  CREDIT 

the  borrower.  The  plant  of  a  manufacturer  should  be 
valued  higher  ordinarily,  it  is  maintained,  than  real 
estate  owned  by  a  jobber  which  is  not  a  necessary  ad- 
junct to  his  business.  Brick,  mortar  and  equipment 
which  might  not  realize  twenty  five  cents  on  the  dollar 
under  forced  sale  should  be  valued  at  a  much  higher 
price  when  owned  and  managed  by  capable  borrowers. 
The  valuation  of  real  estate  is  thus  made  a  function  of 
the  capacity  of  the  borrower.  It  is  also  urged  that  real 
estate  which  is  extraneous  to  the  conduct  of  a  business 
should  be  entirely  stricken  out  or  appraised  on  a 
nominal  basis.  ^  The  cases  in  which  real  estate  even  ap- 
proaches the  character  of  a  quick  asset  are  rare,  and 
its  value  concerns  the  lending  banker  chiefly  in  con- 
nection with  a  long  time  view  of  the  credit  worth  of  the 
borrower. 

As  a  basis  of  appraising  real  estate  employed  in 
manufacturing,  cost  or  cost  of  replacement  is  usually 
unsatisfactory.  What  the  plant  would  sell  for  in  the 
event  of  liquidation  is  the  most  vital  question.  It 
is  evident  that  the  answer  to  this  question  will  hinge 
chiefly  on  location  and  the  nature  of  the  goods  for  the 
production  of  which  the  plant  is  equipped.  In  the  case 
of  a  manufacturing  enterprise,  whose  plant  is  not  cen- 
trally or  well  located,  employed  in  turning  out  goods 
in  the  production  of  which  few  are  engaged, — e.  g., 
Jews'  harps  or  paper  makers'  felt, — land,  plant  and 
equipment  would  have  few  buyers  at  the  time  of  a 
sheriff's  or  receiver's  sale.  If  an  old  plant,  unfavorably 
located  for  the  production  of  a  new  and  different  arti- 

1 W.  Oliver  Craig,  Banking  Credits,  Bulletin,  American  Institute 
of  Bank  Clerks,  Vol.  V,  pp.  708,  709. 


THE  BANK  BORROWER'S  STATEMENT         181 

cle,  would  have  to  be  remodelled  and  newly  equipped 
before  the  creditor  bank  would  be  able  to  realize 
on  the  capital  advanced  as  a  loan,  the  credit  man  had 
better  insist  on  a  nominal  valuation.  If  on  the  other 
hand  the  plant  is  well  located  in  an  industrial  center 
and  employed  in  manufacturing  a  staple  like  some  of 
the  textiles,  for  example,  both  plant  and  machinery 
might  easily  be  sold  on  short  notice  at  a  price  approxi- 
mating cost  of  replacement.  As  the  plant  is  by  far 
the  most  important  single  asset,  quick  or  slow,  in  many 
lines  of  manufacturing,  the  credit  man  is  compelled 
in  fairness  to  the  borrower  as  well  as  by  banking  com- 
petition to  evaluate  this  item  as  liberally  as  safety 
will  permit. 

A  sharp  distinction  should  be  made  generally  be- 
tween real  estate  used  for  manufacturing  and  that  for 
merchandising.  A  business  structure  if  conveniently 
located  for  trade  and  not  adapted  specially  to  any  one 
purpose  is  a  good  asset.  If  the  business  that  may  now 
occupy  it  should  be  withdrawn  the  building  and  lot 
could  be  sold  and  applied  to  other  use.  The  value  of 
the  real  estate  is  easily  appraised  and  the  banker  is 
justified  in  placing  a  relatively  high  value  upon  it. 
The  situation  in  connection  with  a  manufacturing 
plant  is  entirely  different, — if  the  business  fails  it  is 
likely  to  be  difficult  to  apply  the  premises  to  other 
purposes.  As  a  general  rule  the  banker  should  not 
value  the  plant  at  a  higher  figure  than  that  at  which 
experts  in  the  line  of  manufacture  concerned  would  be 
willing  to  take  it  over  as  a  "going  proposition." 

Machinery  is  almost  worthless  as  security  for  a  bank 
loan.     Unless  of  very  high  grade  it  cannot  be  sold 


182  BANK  CREDIT 

usually  for  much  more  than  its  value  as  scrap.  It  is 
far  removed  from  being  a  quick  asset  and  can  be  al- 
lowed weight  in  the  consideration  of  the  credit  man 
only  when  he  knows  the  applicant  for  the  loan  is  pros- 
perous, is  adding  to  working  capital  from  year  to  year, 
and  that  all  the  elements  of  success  are  present.^ 

The  book  value  of  machinery  should  be  steadily 
scaled  down,  unless  the  concern  is  known  by  the  banker 
to  carry  an  offsetting  reser\'e  fund  for  depreciation, — 
a  fund  to  which  is  charged  the  cost  of  machines  bought 
to  replace  those  going  to  the  scrap  heap.  It  is  to  be 
noted  that  concerns  whose  practice  is  to  keep  machin- 
ery at  a  very  high  state  of  efficiency,  maintain  that 
continually  to  charge  off  for  depreciation  rather  than 
carry  a  reserve  fund  is  to  invite  a  reduction  in  fire  in- 
surance below  what  is  equitable  and  reasonable. - 

Whatever  the  nature  of  the  business  of  the  appli- 
cant for  a  loan,  the  items  of  real  estate,  machinery  and 
equipment  should  be  appraised  carefully  and  conser- 
vatively. Machinery  and  equipment  had  better  be 
placed  on  a  nominal  or,  at  most,  a  liquidation  basis  of 
valuation,  the  banker  normally  assuring  himself  as  to 
provision  for  repairs,  renewals,  and  replacements. 

Other  Assets 

Among  the  most  important  items  included  in  ''other 
assets"  are  stocks  and  bonds,  patents,  trade-marks, 

1  William  Post,  The  Analysis  of  Borrowers'  Statements,  Journal  of 
Accountancy,  January,  1906,  pp.  187,  188. 

2  William  Post,  The  Loan  and  Credit  Department,  BuUetin  of  the 
American  Institute  of  Bank  Clerks,  August  1,  1903,  Vol.  Ill,  p.  135. 


THE  BANK  BORROWER'S  STATEMENT         183 

good  will,  and  such  deferred  assets  as  insurance  paid, 
organization  expenses,  taxes  paid  in  advance. 

Stocks  and  Bonds 

Under  the  head  of  other  assets,  or  otherwise,  the 
item  of  stocks  and  bonds  appears  in  a  large  number 
of  borrowers'  statements.  When  the  securities  are 
good  stock  exchange  collateral  they  may  safely  be 
included  in  the  quick  assets.  If  the  securities  are  those 
of  companies  affiliated  with  but  controlled  by  the  one 
under  review,  and  are  of  significant  proportion,  close 
study  should  be  made  of  the  relation  of  the  one  com- 
pany to  the  others  in  order  to  disclose,  if  possible,  any 
contractual  obligation  or  contingent  liability  under 
stock  ownership,  enjoined  by  the  state  in  which  the 
controlled  company  was  organized.^  The  banker  who 
profits  from  past  experience  will  require  a  consolidated 
balance  sheet,  prepared  by  competent  accountants,  of 
a  concern  that  is  financing  branches  and  subsidiaries  in 
order  that  the  standing  of  the  concern  as  a  whole  may 
be  revealed. 

The  reason  for  holding  listed  securities,  if  carefully 
inquired  into,  may  disclose  a  speculative  tendency  in 
the  concern.  A  bank  should  have  all  requisite  informa- 
tion in  an  instance  of  this  kind.  The  customer  may 
have  embarked  on  some  speculation  or  venture  foreign 
to  his  regular  business  which  would  put  him  under 
obUgation  to  pay  instalments  at  successive  dates. 
His  statement  may  show  the  first  one  or  two  pay- 
ments as  an  investment,  and  make  no  mention  of  the 

1  Frederick  H.  Hurdman,  op.  cit.,  p.  474. 


184  BANK  CREDIT 

liability  in  connection  with  the  instalments  not  yet 
due.^ 

Unissued  stocks  and  bonds  of  a  borrowing  corpora- 
tion are  not  an  asset  and  should  not  be  so  shown. 
Treasury  stock,  or  stock  which  has  been  repui'chased, 
must  be  regarded  as  a  slow  asset  unless  a  wide  market 
for  the  stock  exists.  Even  when  the  securities  are 
listed  and  active  on  an  important  exchange  their  value, 
in  the  event  of  failure,  would  be  residual  and  until  the 
completion  of  liquidation,  indeterminate.  Serious 
weakness  may  easily  be  concealed  in  the  ''invest- 
ments" item,  which,  accordingly,  should  be  carefully 
appraised  as  to  both  value  and  ease  and  quickness  of 
sale. 

Trade-marks,  Patents,  Good  Will,  etc. 

Some  or  all  of  these  items  grace  the  statements  of 
many  borrowers.  While  possessing  a  positive  value  as 
long  as  the  company  is  a  going  concern,  their  hqui- 
dation  value  is  likely  to  be  nil.  There  are  exceptions. 
To  take  a  concrete  case,  the  makers  of  Ivory  Soap  could 
probably  realize  substantially  on  the  sale  of  the  name, 
which  is  the  trade-mark,  even  if  all  tangible  property 
of  the  concern  were  destroyed  by  fire  with  no  insurance. 
The  value  of  this  trade  mark  has  been  built  up  in  large 
measure  by  heavy  advertising  over  a  long  period  of 
years  and  that  fact  would  in  itself  justify  the  lending 
banker  in  allowing  the  borrower  to  place  a  relatively 
high  valuation  on  the  trade-mark  as  an  asset. 

1  Journal  of  the  Canadian  Bankers'  Association,  Vol.  XXIII, 
No.  4,  July,  1916. 


THE  BANK  BORROWER'S  STATEMENT         185 

Trade-marks  are  probably  easier  of  satisfactOTy 
appraisal  than  patents,  copyrights  and  good  will. 
Nevertheless  bankers  are  not  infrequently  influenced 
favorably  by  the  known  existence  of  value  attaching 
to  such  assets  as  we  have  under  consideration,  even 
though  they  are  listed  at  only  nominal  valuations. 
Many  concerns  of  high  class  credit  standing  give  evi- 
dence of  their  conservatism  by  carrying  some,  if  not  all, 
of  this  group  of  items  in  the  balance  sheet  at  a  purely 
nominal  figure.  A  case  in  point  is  the  General  Electric 
Company.  Other  concerns  take  full  advantage  of 
the  vagueness  and  indefiniteness  with  which  these  in- 
tangible assets  are  surrounded.  When  having  little  or 
no  value  at  all,  the  items  may  be  placed  on  the  books  at 
a  high  valuation  in  order  to  offset  a  certain  amount 
of  liabilities.  Patents,  trade-marks,  good  will,  and 
copyrights,  when  swollen  in  size,  put  the  credit  man 
on  guard. 

Deferred  assets,  such  as  taxes  paid  in  advance, 
insurance  premiums,  and  organization  expenses  make 
only  a  casual  claim  on  the  credit  man's  attention.  Cer- 
tainly taxes  paid  are  not  likely  to  be  returned  to  the 
business  of  the  taxpayer,  however  prosperous  that 
business  may  be.  It  might  be  legally  possible  to  re- 
cover a  part  of  insurance  premiums  in  the  event  of 
liquidation,  but  the  amount  would  be  small  in  any  case. 
Organization  expenses  are  assets  in  a  technical  sense 
rather  than  actually, — assets  that  the  banker  likes 
to  see  dwindle  and  disappear  within  a  few  years  after 
the  enterprise  has  been  launched.  Appraisal  of  de- 
ferred assets  is  about  the  least  of  the  credit  man's 
troubles. 


186  BANK  CREDIT 


Life  Insurance 


Increasingly  banks  are  including  in  the  blank  state- 
ments furnished  their  borrowing  customers  one  or  more 
questions  as  to  life  insurance. 

Life  insurance  is  not  infrequently  used  to  support 
the  element  of  moral  hazard.  Even  insurance  that 
does  not  carry  with  it  cash  value  upon  surrender  is 
looked  upon  by  bankers  as  excellent  credit  support 
under  certain  circumstances.  If  the  borrower  is  a  man 
of  known  integrity  and  ability,  but  without  capital, 
term  insurance  or  insurance  in  other  form  on  the  life 
of  the  applicant  for  a  loan  may  be  acceptable  to  the 
banker  in  lieu  of  capital.  In  the  event  of  failure  of  one 
project,  insurance  on  the  life  of  the  borrower  enables 
the  banker  to  await  with  confidence  the  outcome  of 
another  more  successful  venture.  By  the  same  token 
life  insurance  is  in  many  cases  a  satisfactory  substitute 
for  endorsement.  Men  with  otherwise  excellent  pros- 
pects of  success  and  entitled  by  character  to  great 
confidence  w^ould  be  barred  from  a  successful  start 
and  advancement  in  business  but  for  this  form  of 
support  or  endorsement.^  It  is  just  as  essential  to 
credit  when  great  reliance  is  placed  on  the  integrity 
and  business  capacity  of  the  borrower  as  is  fire  in- 
surance where  the  chief  reliance  is  on  the  value  of 
merchandise  or  other  similar  assets.  As  most  unse- 
cured loans  ought  to  rest  on  all  three  bases  of  capital, 
capacity,  and  character,  it  follows  that  life  insurance 
in  being  employed  as  a  foundation  of  credit  serves  a 

1  William  T.  Gage,  Life  Insurance  as  Collateral,  Proceedings, 
Twenty  Seventh  Convention,  Michigan  Bankers'  Association,  1913, 
p.  129. 


THE  BANK  BORROWER'S  STATEMENT         187 

useful  and  proper  purpose.  Life  insurance  is  contin- 
gent capital. 

Policies  are  now  being  written,  frequently  in  large 
amounts,  to  cover  losses  contingent  upon  the  death  of 
partners,  the  managing  geniuses  of  corporations, 
inventors  connected  with  business  enterprises  and 
others  upon  whom  success  is  largely  dependent.^  The 
death  of  a  member  of  a  firm  may  involve,  not  only  the 
loss  of  his  active  cooperation  in  the  management,  but 
also  the  withdrawal  of  his  capital  from  the  business. 
Bankers  often,  in  checking  corporations  and  firms  sell- 
ing paper  in  the  open  market,  find  the  suggestion  that 
this  or  that  banker,  owing  to  the  death  of  the  founder 
or  manager  of  the  business  under  investigation,  has 
discontinued  purchasing  its  paper  until  such  time  as 
the  new  organization  will  have  shown  its  ability  to 
manage  its  affairs  successfully.  The  situation  would  be 
materially  improved,  if  in  response  to  the  banker's 
inquiry,  he  were  informed  that  the  company,  while 
losing  a  capable  officer,  had  collected  a  large  amount  of 
insurance.^ 

Life  insurance  is  a  stabilizing  force,  destined  more 
and  more  to  reduce  and  absorb  the  shocks  of  those 
financial  vicissitudes  to  which  business  is  everywhere 
subject. 

'  A.  Barton  Hepburn,  The  Relation  of  Life  Insurance  to  the  Credit 
Fabric  of  Business,  An  Address  delivered  at  the  Eighth  Annual 
Meeting  of  the  Association  of  Life  Insurance  Presidents,  New  York, 
December  10,  1914,  p.  6. 

2  W.  W.  Smith,  Necessity  for  Credit  Statements  and  Desirability  of 
Uniformity  Thereof,  Proceedings,  Forty  Second  Annual  Convention, 
American  Bankers'  Association,  1916,  p.  519. 


188  BANK  CREDIT 

We  have  dwelt  at  length  on  the  treatment  of  the 
assets  side  of  the  borrower's  balance  sheet  because 
there  concealed  are  most  of  the  banker's  pitfalls.  What 
a  borrower's  assets  amount  to  is,  as  we  have  seen, 
largely  a  matter  of  appraisal.  His  liabilities,  on  the 
other  hand,  need  only  to  be  fully  Usted  in  order  to  be 
accurately  known.  The  discussion  of  the  borrower's 
liabilities,  as  viewed  by  the  banker,  may  therefore  be 
put  into  brief  compass. 


CHAPTER  IX 

The  Bank  Borrower's  Statement: 

Liabilities 

Liabilities  have  already  been  classified  and  we  may 
pass  at  once  to  their  analysis  and  interpretation, 
following  the  order  of  the  liabihty  items  of  the  balance 
sheet  given  near  the  beginning  of  the  previous  chapter. 

Bills  Payable  for  Merchandise 

This  item  should  normally  be  small;  otherwdse  it 
would  indicate  failure  to  take  discounts.  Such  failure 
might  be  traceable  to  carelessness,  overtrading  or 
backward  collections, — in  any  event  an  unfavorable 
indication.  In  certain  trades  like  the  lumber,  building 
trades,  some  branches  of  the  tobacco  business,  etc.,  it 
is  customary  for  the  buyer  to  give  notes  in  settlement  of 
accounts.  Unless  it  is  the  custom  of  the  trade  to  settle 
in  this  way,  bills  payable,  if  large  in  amount,  are  an 
almost  certain  sign  that  the  concern  is  "skating  on 
thin  ice." 

Bills  Payable  to  Own  Banks 

It  is  a  distinctly  unfavorable  sign  if  a  firm  borrowing 
heavily  from  a  bank  allows  its  bills  to  run  to  maturity 
or  past  maturity.  Cautious  bankers  make  trade  in- 
vestigations and  revise  their  credit  files  every  six 
months  or  every  year;  and  if  they  learn,  as  a  result  of 

189 


190  BANK  CREDIT 

inquiries,  that  their  borrowers  are  not  taking  advan- 
tage of  the  best  trade  discounts,  the  matter  is  brought 
to  the  attention  of  borrowers  at  once.  There  are  times 
of  course  when  abnormal  business  conditions  prevent 
the  banker  from  being  exact  in  enforcing  this  rule. 
Usually  its  enforcement  is  prompted  by  good  banking 
and  business  logic. ^ 

It  is  advisable  for  the  banker  to  know  the  maximum 
amount  borrowed  from  all  sources  during  the  pre- 
vious fiscal  year  because  most  concerns  close  their 
books  and  make  up  annual  statements  between  seasons 
when  their  business  is  employing  a  minimum  of  bor- 
rowed funds,  or  none  at  all.  Between  the  dates  when 
habihties  are  at  a  maximum  and  at  a  minimum,  the 
proportion  of  quick  assets  to  current  habihties  changes 
markedly. 

Bills  Payable  for  Paper  Sold 

Many  cases  have  occurred  in  recent  years,  notably 
a  decade  ago,  where  borrowers  discounted  their  paper 
through  note  brokerage  houses  and  dehberately  omit- 
ted from  their  statements  an  appreciable  part  of  such 
liabihty.  This  deceptive  practice  has  been  checked, 
chiefly,  by  more  painstaking  work  on  the  part  of  bank 
examiners.  Clearing  house  bank  examinations  have 
been  particularly  effective  ui  checking  this  practice. 
Although  the  clearing  house  examiner  does  not  come  in 
touch  with  paper  held  by  outside  banks,  the  borrower 
can  never  tell  when  the  brokerage  house  or  possibly 

^  Joseph  B.  Martindale,  The  Business  of  a  Commercial  Bank  and 
How  to  Safeguard  the  Investment  of  Its  Funds,  Proceedings,  Thirty- 
Seventh  Annual  Convention,  American  Bankers'  Association,  1911, 
pp.  702, 703. 


THE  BANK  BORROWER'S  STATEMENT         191 

country  bank  may  resell  paper  to  one  of  the  banks  over 
which  the  clearing  house  examiner  has  supervision. 
There  is  at  least  a  moral  effect. 

Open  Accounts 

Bankers  should  ascertain  how  the  amount  of  ac- 
counts payable  is  ascertained.  When  this  item  is 
small  it  may  be  explained  by  the  bookkeeping  practice 
of  keeping  no  record  of  the  accounts  payable  until  the 
accounts  are  paid.  The  item,  under  those  circum- 
stances is  placed  on  the  statement  at  an  estimated 
amount,  which  may  not  fully  represent  this  class  of 
indebtedness  at  the  statement  date.  Accounts  payable 
may  also  be  reduced  in  the  statement  as  a  result  of  the 
bookkeeper  placing  no  bills  upon  the  books  until  they 
have  been  audited  and  approved.^ 

It  is  not  an  uncommon  practice  to  offset  accounts 
payable  by  accounts  receivable.  When  a  statement  is 
made  showing  accounts  payable  net,  after  deducting 
certain  of  the  receivables  there  has  been  a  misrepre- 
sentation. A  liability  almost  invariably  represents 
one  hundred  cents  on  the  dollar,  but  an  asset  repre- 
sents only  what  can  be  realized  on  it.  Any  offset  of 
liabilities  against  assets  is  misleading  unless  that  offset 
is  clearly  shown  in  the  statement.  In  the  same  cate- 
gory should  be  placed  such  accounts  as  represent,  for 
example,  investment  in  foreign  branches.  The  state- 
ment may  reveal  only  the  net  investment,  whereas  to 
be  of  positive  value  both  the  assets  and  liabilities 
should  be  given. ^    This  practice,  while  apparently  not 

1  Frederick  H.  Hurdman,  op.  cit.,  p.  476. 
*C/.  oif).  cit.,  p.  471. 


192  BANK  CREDIT 

changing  the  net  worth  of  a  concern  does  give  its  state- 
ment an  improved  appearance.  Many  borrowers 
beUeve,  with  some  reason,  that  they  have  presented  a 
stronger  statement  when  they  show  assets  of,  say, 
$150,000  with  nominal  liabihties  than  if  they  showed 
assets  of  $200,000  and  Habihties  of  $50,000. 

Chattel  Mortgages 

The  existence  of  a  chattel  mortgage  is  so  evidently 
an  unfavorable  sign  as  scarcely  to  deserve  emphasis. 
"Indebtedness  for  back  rent  or  a  chattel  mortgage 
on  fixtures  or  horses  and  wagons  is  a  sure  sign  of  finan- 
cial weakness."^ 

Bonded  Debt  and  Interest  Thereon 

With  reference  to  bonded  debt  and  interest  thereon 
the  banker  should  know,  among  other  things,  the 
redemption  date  and  the  amount  of  interest  accrued. 
The  early  maturity  of  a  mortgage  or  mortgage  bonds 
should  not  escape  attention,  especially  if  the  prospect  of 
renewal  or  refunding  is  unfavorable.  If  the  redemption 
date  of  the  bonds  is  near  at  hand  and  pro\'ision  for 
their  refunding  doubtful  the  banker  may  feel  justified 
in  regarding  the  principal  as  a  current  liability.  Ac- 
crued interest,  when  it  amounts  to  a  large  sum,  is 
obviously  a  clear  sign  of  weakness.  Sinking  fund  pro- 
visions which  have  not  been  Hved  up  to  represent  un- 
questionable impairment  of  strength. 

1  Herman  Flatau,  Financial  Statements,  Their  Form  and  Analysis, 
in  Mercantile  Credits,  A  Series  of  Practical  Lectures  delivered  before 
the  Young  Men's  Christian  Association  of  Los  Angeles,  California, 
1914,  p.  78. 


THE  BANK  BORROWER'S  STATEMENT         193 

Whether  a  borrowing  concern  has  mortgage  bonds 
outstanding  or  has  borrowed  on  the  simple  security 
of  real  estate  pledged  by  mortgage,  the  bank  credit 
man  usually  scrutinizes  the  indenture  in  order  to  as- 
certain whether  the  instrument  covers  the  land  and 
buildings  only  or  machinery,  stock  of  goods,  and  other 
chattels,  also.  He  is  never  pleased  to  discover  that  the 
mortgage  overlaps  and  includes  such  free  assets  as 
equipment,  or  merchandise  and  cash.  "Whenever  such 
a  mortgage  exists  the  liquidation  claims  of  the  lending 
bank,  like  those  of  other  general  creditors,  are  weak- 
ened. A  thin  equity  should  put  the  credit  man  on 
guard  against  the  possibility  of  an  overlapping  inden- 
ture. 

Deposits  of  Money  with  Us 

This  item  is  a  very  important  one.  Deposits  of  this 
nature  are  usually  made  by  the  families  of  members 
of  the  firm  or  by  employees, — in  either  case  interest  is 
almost  certainly  paid  upon  the  amount  deposited. 
Whatever  representations  the  bank  borrower  makes 
as  to  the  likelihood  of  such  advances  never  being  with- 
drawn, the  conservative  banker  will  commonly  regard 
such  an  item,  if  large,  as  pregnant  with  uncomfortable 
possibilities,  inasmuch  as  these  deposits  are  advanced 
by  persons  who  would  be  in  a  position  to  learn  of  im- 
pending disaster  before  any  of  the  other  creditors  and 
in  time  to  secure  the  necessary  preference  for  their  own 
protection.  Here  is  a  case  in  point.  A  firm  failed, 
paying  fifty  cents  on  the  dollar,  it  being  more  than  sus- 
pected that  a  number  of  women, — members  of  the 
family, — who   had   advanced   money,   had   been   just 


194  BANK  CREDIT 

previously  to  the  collapse  of  the  concern  paid  off  or  se- 
cured at  the  expense  of  the  other  creditors.^ 

The  contention  of  many  business  men  that  the 
appearance  of  large  deposit  accounts  in  the  statement 
indicates  additional  security,  as  those  closely  inter- 
ested are  shown  to  be  willing  to  entrust  their  money  to 
the  concern,  loses  its  force  when  we  remember  that 
those  closely  associated  with  the  managers  or  principals 
may  be  in  a  position  to  scent  danger  earlier  than  the 
banker  and  other  creditors  and,  having  secured  the 
repayment  of  their  own  advances,  place  the  burden  of 
the  enterprise,  weakened  by  the  withdrawal  of  the 
"deposits,"  on  the  shoulders  of  the  bankers  and  general 
creditors. 

Other  Liabilities 

Other  liabilities  not  mentioned  in  the  list  on  page 
163  may  be  very  varied.  Accrued,  deferred  and  con- 
tingent liabihties  alone  seem  to  call  for  comment. 

Some  bankers  treat  contingent  liabilities,  which 
usually  arise  from  endorsed  and  discounted  notes  re- 
ceivable or  endorsements  for  accommodation,  as  a  part 
of  the  borrower's  current  habihties.  To  do  so  where 
such  contingent  habilities  are  heavy  changes  the  ratio 
of  quick  assets  to  current  liabilities  very  unfavorably 
to  the  borrower.  Let  us  suppose  a  borrower  presents 
a  statement  showing 

Quick  Assets $200,000    Current  Liabilities |  50,000 

Permanent  Assets 200,000    Pennanent  Liabilities .  .  350,000 

$400,000  $400,000 

1  William  Post,  Analysis  of  Borrowers'  Statements,  Journal  of 
Accountancy,  Vol.  I,  No.  3,  January,  1906,  p.  189. 


THE  BANK  BORROWER'S  STATEMENT  195 

The  borrower  would  have,  according  to  this  statement, 
a  ratio  of  quick  assets  to  current  liabihties  equal  to 
4:1.  If  a  bank  loaned  the  maker  of  the  statement 
$50,000,  the  ratio  of  quick  assets  to  current  liabilities 
would  be  23^  to  1,  a  ratio  that  is  commonly  regarded 
as  safe.  If  contingent  Uabilities  amounting  to  $150,000 
arising  from  customers'  notes  discounted  are  discov- 
ered, however,  the  face  of  the  statement  becomes 
changed  decidedly  for  the  worse;  if  the  contingent 
Uabihties  are  looked  upon  as  an  addition  to  the  current 
liabilities,  the  ratio  of  quick  assets  to  current  liabilities 
would  become  1  to  1.  Some  bankers  are  inclined  to 
treat  contingent  liabilities  as  we  have  done  here, 
although  it  is  an  extremely  conservative  practice. 

Accrued  Uabilities,  corresponding  to  accrued  assets, 
are  exemplified  by  wages  payable,  taxes  payable,  rent 
payable,  interest  payable.  Deferred  liabilities  differ 
from  accrued  in  being  paid  finally,  not  in  cash,  but  in 
services  or  commodities, — in  product.  Milk  tickets 
outstanding  in  the  hands  of  customers  and  for  which 
payment  had  been  received  by  a  dairy  company  would 
stand  for  a  deferred  liabihty  of  the  company.  Prepay- 
ments in  connection  with  services  or  products  give  rise 
to  deferred  liability  items  on  the  books  of  the  concern 
receiving  the  payment.  Deferred  liabilities  are  dis- 
tinctive but  generally  of  less  importance  to  the  lending 
banker  than  accrued  liabilities. 

The  absence  of  accrued  liabilities  in  the  statement 
may  usually  be  taken  as  evidence  that  the  accounts  of 
the  concern  have  not  been  accurately  kept.  Where 
accruals  for  taxes,  interest,  rent  and  other  items  appear, 
an  effort,  at  least,  may  have  been  made  to  ascertain 


196  BANK  CREDIT 

exactly  the  operating  results  of  the  period  under  re- 
view and  the  condition  of  the  affairs  of  the  concern  at 
the  date  of  statement.  The  discovery  only  after  in- 
vestigation that  taxes  or  interest  in  large  amount,  but 
not  mentioned  in  the  statement,  are  soon  to  fall  due  is 
not  calculated  to  inspire  confidence  in  the  banker  as  to 
the  seciu-ity  of  the  loan  sought.  Although  it  is  fre- 
quently asserted  that  no  Uabihty  should  be  set  up  for 
such  items  as  interest,  taxes,  and  rent  until  they  fall 
due,  the  conservative  and  correct  practice  is  to  make 
these  items  accrue  regularly  so  that  the  earnings  and 
financial  condition  may  be  stated  accurately. 

Capital  and  Surplus,  Proprietorship  Interest  or 
Net   Worth 

A  business  corporation  as  well  as  a  bank  ought  to 
have  a  capital  sufficient  to  support  its  volume  of  busi- 
ness. In  national  and  most  state  banking  corporations 
capital  is  more  highly  protective  to  depositors  and 
other  creditors  than  is  surplus  because  of  the  double 
hability  of  stockholders  in  those  institutions.  In 
business  corporations,  where  limited  Hability  of  share- 
holders generally  prevails,  surplus,  as  long  as  it  exists, 
affords  protection  in  the  same  degree  as  does  capital. 
It  is  an  interesting  commentary  on  the  question  of  the 
existence  of  actual  smplus  in  American  corporations 
that  of  those  whose  securities  are  listed  on  our  fore- 
most stock  exchange  and  selHng  below  par  over  long 
periods  of  time  a  great  majority  show  hook  surpluses. 
It  must  be  evident  that  surplus  can  be  easily  manip- 
ulated simply  by  changing  the  valuation  of  items  in 
the  balance  sheet. 


THE  BANK  BORROWER'S  STATEMENT         197 

When  the  borrowing  concern  is  an  individual  or  a 
partnership,  capital  and  surplus  combined  take  the 
form  of  net  worth.  Relatively  small  net  worth  may 
be  fully  offset  occasionally  by  other  and  outside  re- 
sources of  the  borrower.  The  reader  will  of  course 
have  in  mind  the  fact  that  limited  liability  does  not 
commonly  pertain  to  the  partnership.  But  whether 
the  application  for  a  loan  comes  from  a  corporation  or 
some  other  form  of  business  organization  the  lending 
banker,  if  conserv^ative,  must  insist  on  a  satisfactorily 
large  capital  investment  and  protection.  Lack  of 
capital  entails  constant  strain  on  the  borrower  and 
renders  him  a  prey  to  adverse  business,  credit,  or 
collection  conditions. 

Ratio  of  Quick  Assets  to  Current  Liabilities 

Credit  men  are  even  more  concerned  about  the 
ratio  of  quick  assets  to  current  liabilities  than  they  are 
about  the  net  worth  or  capital  and  surplus  of  the  appli- 
cant for  a  loan.  Net  worth  may  be  very  great  but  in 
the  form  of  slow  assets.  The  banker  fails  to  safeguard 
the  interests  of  his  depositors  and  shareholders  unless 
he  uniformly  insists  on  a  safe  ratio  of  quick  assets  to 
current  liabilities.  What  constitutes  a  safe  ratio  varies 
from  case  to  case,  but  hovers  around  2  to  1,  after  the 
desired  loan  has  been  included.  Allowance  for  a 
shrinkage  of  50  per  cent  is  generally  regarded  as  suffi- 
cient and  when  the  moral  risk  is  exceptionally  good, 
earnings  highly  satisfactory  or  slow  assets  relatively 
large,  a  ratio  of  very  appreciably  less  than  2  to  1  may 
be  acceptable.  Departure  from  the  2  to  1  rule  is  very 
common. 


198  BANK  CREDIT 

Relation  of  Net  Worth  to  Credit  Worth 

WTiat  is  the  proper  and  safe  relation  between  net 
worth,  the  proprietorship  interest,  or  capital  and  sur- 
plus on  the  one  hand  and  credit  worth  on  the  other? 
It  is  maintained  in  banking  circles  that  unsecured  loans 
should  not  be  made  greatly  to  exceed  one  third  of  the 
net  worth,  where  the  banker  is  well  acquainted  with 
the  business,  ability,  and  morals  of  the  borrower.^ 
Nevertheless  the  ratio  varies  widely  from  banker  to 
banker  and  from  borrower  to  borrower.  Even  the 
bank  balance  maintained  by  the  applicant  for  a  loan 
will  be  one  of  the  determining  factors.  No  hard  and 
fast  rule  can  be  laid  down. 

1  Robert  A.  Parker,  Practical  Credit,  Bulletin  of  American  Insti- 
tute of  Bank  Clerks,  Vol.  VI,  p.  354. 


CHAPTER  X 

The  Bank  Borrower's  Statement: 

The  Income  Account 

Although  the  asset  and  habiUty  statement  is  some- 
times submitted  with  an  appHcation  for  credit,  without 
a  statement  of  income  and  expenses,  the  latter  is  of 
indispensable  value  to  the  credit  man  in  reaching  an 
intelligent  decision.  The  one  mirrors  a  condition  on  a 
given  date;  the  other  shows  how  that  condition  was 
achieved,  and  indicates  the  trend  of  the  business, 
whether  favorable  or  unfavorable.  Deficiencies  in  the 
balance  sheet  may  be  outweighed  by  substantial  and 
steadily  growing  profits  reflected  in  the  income  ac- 
count. A  thriving  business  with  growing  profits  is  a 
more  satisfactory  credit,  even  if  the  ratio  of  quick 
assets  to  current  liabilities  is  comparatively  low,  than 
a  concern  showing  a  liberal  margin  of  assets  but  with  a 
dwindling  profit  and  loss  account.  One  is  growing 
constantly  stronger,  the  other  less  and  less  desirable  as 
a  risk.    One  inspires  confidence,  the  other  apprehension. 

Many  applicants  for  loans  who  submit  balance 
sheets  are  still  reluctant  to  include  a  statement  of 
profit  and  loss  account,  and  some  compromise  by  giving 
merely  the  final  net  profit  (or  loss).  A  complete  profit 
and  loss  statement  ought  to  be  obtained  and  care- 
fully scrutinized  because  of  the  light  it  may  throw 
upon  the  items  in   the  balance  sheet.     The  banker 

199 


200  BANK  CREDIT 

must  make  sm*e  that  the  credits  do  not  represent  sales 
of  assets.  Let  him  also  compare  the  debts  with  prev- 
ious statements  in  order  to  check  the  omission  or  re- 
duction of  charges  like  depreciation,  a  practice  some- 
times resorted  to  in  order  to  make  a  creditable  showing 
of  earnings  in  poor  years.  "The  capitahzation  of 
repairs  and  maintenance  pads  the  profits  as  well  as 
the  permanent  assets  accounts."  ^ 

A  condensed  profit  and  loss  statement  or  income 
account  of  the  following  character  contains  the  main 
items  of  expense  and  income: 

Expense 

Cost  of  material  or  merchandise  consimied $ 

Actual  expense  of  conducting  business: 

Including  rent,  taxes,  insurance,  etc 

Salaries  paid  to  officers 

Interest  on  borrowed  money  and  bonds 

Bad  debts  charged  off 

Depreciation  charged  off 

Net  profits 

Total $ 

Income 

Net  sales $ 

From  investments 

From  discounts  on  purchases 

From  other  sources 


Total $ 

^  Clay  Herrick,  Borrowers'  Statements  and  the  Rulings  of  the 
Federal  Reserve  Board,  Proceedings,  Twenty-Fifth  Annual  Conven- 
tion, Ohio  Bankers'  Association,  1915,  pp.  51,  52. 


THE  BANK  BORROWER'S  STATEMENT         201 

Items  among  the  expenses  that  call  especially  for 
comment  are  expenses  of  conducting  the  business, 
salaries  paid  officers,  and  depreciation.  The  others 
are  self-explanatory  or  scarcely  call  for  comment. 

The  actual  expense  of  conducting  the  business  is 
an  index  of  capacity  and  is  closely  watched  by  the 
careful  credit  man.  Large  banks  with  well  equipped 
credit  departments,  having  several  customers  engaged 
in  the  same  Une  of  trade  or  manufacture,  are  able  to 
compare  this  item  advantageously  to  both  the  bank 
and  the  borrowing  concerns  whose  expenses  are  rela- 
tively high. 

The  cost  system  of  the  borrower  should  receive  very 
special  attention,  ''for  it  is  in  the  cost  system  that 
money  is  most  generally  made  or  lost,"^  Without  a 
well  developed  cost  system  a  borrower  cannot  have  a 
thorough  grasp  of  his  business. 

Insurance 

Insurance  is  an  item  that  does  not  escape  the 
banker's  attention.  The  banker  looks  upon  failure  to 
insure  adequately  with  great  disfavor  for  two  reasons: 
such  failure  jeopardizes  the  safety  of  the  credit  ex- 
tended and  also  indicates  a  lack  of  business  capacity 
on  the  part  of  the  borrower. 

Salaries  and  Cash  Withdrawals 

Salaries  paid  to  officers  deserve  scrutiny.  If  salaries 
paid  represent  amounts  withdrawn  from  a  business  by 

'  Thomas  J.  Kavanaugh,  Essentials  in  the  Granting  of  Bank 
Credits,  Principles  and  Methods  rvhich  Should  be  Observed,  Trust 
Companies,  Vol.  XXIII,  No.  2,  August,  1916,  p.  120. 


202  BANK  CREDIT 

its  members  for  living  expenses,  such  withdrawals  may 
throw  strong  light  on  the  moral  risk.  High  living  has 
a  doubly  unfavorable  action.  There  is  an  actual  and 
perhaps  serious  danger  to  the  stability  of  the  business 
occasioned  by  the  withdrawal  of  funds  to  meet  the 
expenses  of  an  extravagant  mode  of  life,  and  in  addi- 
tion high  and  reckless  living  may  invite  heavy  costs 
in  defending  suits  or  in  satisfying  court  judgments  or 
decrees. 

Depreciation 

Depreciation  is  a  cloak  that  may  conceal  the  source 
of  "unearned"  profits.  The  smaller  the  amount 
allowed  for  depreciation  the  greater  the  book  profits. 
Accordingly,  the  banker  needs  to  compare  depreciation 
year  after  year  in  order  to  assure  himself  that  adequate 
and  reasonably  uniform  provision  is  made  for  the  wear 
and  tear  and  obsolescence  of  plant  and  equipment.  If 
the  plant  is  overworked  a  heavier  charge  should  be 
found  in  this  item.^ 

Where  liberal  amounts  for  depreciation  are  charged 
off  over  long  periods  and  when  betterments  and  exten- 
sions are  charged  to  operating  account  rather  than  to 
capital  account  the  earning  power  of  the  concern  tends 

1  It  is  easy  for  the  bookkeeper  to  create  "book"  profits.  If  the 
business  of  the  borrower  has  been  below  normal  in  results  a  portion 
of  what  should  be  placed  in  operating  accounts,  such  as  repairs  or 
renewals,  may  be  charged  to  a  building  or  fixture  account.  The 
method  or  basis  of  inventory  may  be  changed,  the  inventory  item 
and  net  worth  inflated.  The  amount  set  aside  for  bad  debts  may  be 
reduced.  These  and  other  ways  of  manipulating  the  statement  may 
be  employed  to  demonstrate  that  a  thriving  state  of  affairs  exists 
when  the  opposite  condition  really  obtains. 


THE  BANK  BORROWER'S  STATEMENT         203 

to  grow  in  relation  to  its  capitalization.  Many  New- 
England  cotton  mills  have  followed  this  policy  to  such 
an  extent  that  the  value  of  their  output  is  frequently 
several  times  their  capitalization.  As  a  result  they 
have  distinctly  enhanced  their  credit  position.  New 
England  cotton  mill  paper  has  long  sold  at  compara- 
tively low  rates  and  has  been  regarded  highly  by  the 
banks.  The  mills  have  been  able,  on  account  of  their 
easy  financial  condition,  to  take  advantage  of  the 
market  from  time  to  time  either  in  buying  raw  material 
or  in  disposing  of  the  manufactured  product.  The 
location  of  the  mills,  also,  has  been  partly  responsible 
for  the  low  rates  at  which  money  has  been  placed  at 
their  disposal.  The  New  England  mills  are  geograph- 
ically a  part  of  the  great  money  centers,  a  circum- 
stance that  promotes  a  close  personal  acquaintance 
between  the  mill  and  the  banker,  enabling  the  banker, 
moreover,  to  investigate  more  easily  the  condition  of 
the  mills  as  prospective  borrowers.^ 

Packing  companies  and  other  companies  such  as 
shoe,  clothing,  and  other  manufacturers  permanently 
located  are  governed  in  their  depreciation  charges  by 
the  appreciation  or  depreciation  in  real  estate,  the  life 
and  cost  of  up-keep  of  their  buildings,  machinery,  etc. ; 
but  there  are  other  companies  such  as  those  manufac- 
turing timber  products  that  are  further  controlled  by 
the  supply  of  raw  material  in  their  territory  and  it 
usually  becomes  necessary  for  such  companies  to  write 
off  their  entire  plants  in  time  to  cost  of  production  as  it 

1  Daniel  G.  Wing,  New  England  and  South  Carolina,  Proceedings, 
Fifth  Annual  Convention,  South  Carolina  Bankers'  Association, 
1905,  pp.  48,  49. 


204  BANK  CREDIT 

does  not  pay  to  move  them  when  the  supply  becomes 
exiiausted.  With  such  companies  it  is  usually  calcu- 
lated that  their  plants  should  not  exceed  one  dollar 
per  thousand  feet  of  timber  owned  by  them.  How- 
ever, in  some  cases  where  large  supply  of  custom  timber 
is  available,  such  a  rule  should  not  rigidly  apply.  In 
shoe  companies  and  printing  companies,  etc.,  depre- 
ciation of  machiner}^  through  wear  and  tear  and 
obsolescence  is  severe,  and  it  should  be  ascertained 
whether  or  not  write-offs  are  commensurate.  Depre- 
ciation ties  inventory  for  place  of  first  importance  in  a 
financial  statement.  They  are  the  two  magnitudes 
the  exact  status  of  which  it  is  hardest  to  ascertain  and 
many  borrowers  fool  both  themselves  and  their  banks 
in  both  items.  ^ 

Sales 

Few  items  in  the  income  account  are  more  significant 
than  that  of  sales.  The  volume  of  sales  divided  by 
the  inventory,  in  the  case  of  a  mercantile  concern 
gives  the  rate  of  turnover  and  turnover  in  any  given 
line  of  trade  is  an  excellent  index  of  the  quahty  and 
character  of  the  inventory  itself.  We  say  any  given 
business  because  the  turnover  varies  decidedly  from 
business  to  business.  A  staple  business  handling  stock 
easily  replenished  hke  a  wholesale  grocery  would  have 
to  carry  no  more  than  two  or  three  weeks'  sales.  A 
retailer  of  furs  on  the  other  hand  would  show,  if  mak- 

1  Thomas  J.  Kavanaugh,  Essentials  in  the  Granting  of  Bank 
Credits,  Trust  Companies,  Vol.  XXIII,  No.  2,  August,  1916,  pp.  119, 
120. 


THE   BANK  BORROWER'S  STATEMENT         205 

ing  his  statement  in  October,   an  inventory  almost 
equal  to  his  year's  business.^ 

Again,  a  comparison  of  sales  and  accounts  receivable 
enables  the  credit  man  to  determine  the  age  of  the 
latter.  Where  merchandise  is  small  and  accounts 
receivable  large  there  is  an  indication  of  slow  collec- 
tions, of  stale  accounts.  In  such  a  case  the  credit  man 
will  likely  insist  on  a  high  ratio  of  quick  assets  to  cur- 
rent liabilities. 

Net  Profits 

In  comparing  the  net  profits  of  a  concern  from  year 
to  year  or  period  to  period,  the  banker  expects  to  see 
improvement  but  not  necessarily  improvement  every 
year.  In  fact  it  inspires  confidence  in  the  truthfulness 
of  the  showing  if  a  year  or  two  are  found  when  condi- 
tions precluded  the  probability  of  profit  in  the  given 
line  and  the  statement  reflects  those  conditions.  An 
unbroken  symmetrical  gain  should  put  the  banker  on 
his  guard.  Too  much  money  made  in  a  single  year  may 
in  some  instances  suggest  speculation.^ 

Collateral  information  relative  to  earnings  is  always 
illuminating,  Mr.  Clay  Herrick^  cites  the  case  of  a 
company  that  showed  a  statement  of  such  character 
that  on  it  as  a  single  basis  any  banker  would  have  been 
tempted  to  advance  funds  freely.     Assets  were  large, 

1  F.  B.  Snyder,  Credits,  Money  and  Commerce,  February  17, 1917. 

2  F.  W.  Crane,  Commercial  Paper  Bought  from  Brokers,  Thirty- 
sixth  Annual  Convention,  Illinois  Bankers'  Association,  1916, 
p.  138. 

« Clay  Herrick,  Borrowers'  Statements  and  the  Ridings  of  the 
Federal  Reserve  Board,  Proceedings,  Twenty-fifth  Annual  Conven- 
tion, Ohio  Bankers'  Association,  1915,  p.  52. 


206  BANK  CREDIT 

net  worth  was  large.  Earnings  for  a  long  period  had 
been  strikingly  good.  Investigation,  however,  devel- 
oped the  fact  that  a  lucrative  contract  which  was  the 
basis  of  the  concern's  large  earnings  and  then  flourish- 
ing condition  was  about  to  expire  without  possibility 
of  renewal. 

Dividends 

The  banker  is  always  interested  in  the  dividends 
paid  by  a  borrowing  corporation.  A  dividend  record 
in  itself  throws  some  light  on  the  earning  power  and 
credit  worth  of  the  borrower — after  the  banker  has 
assured  himself  that  the  dividends  paid  have  been  jus- 
tifiable. On  the  other  hand  dividends  create  a  void  to 
fill  which  the  banker's  advances  may  be  sought.  Divi- 
dends may  be  much  less  than  earnings  and  still  be 
improper.  If  the  earnings  of  a  corporation  for  a  given 
year  are  $100,000  and  during  the  same  period  $50,000 
are  turned  into  improvements,  and  the  concern  at  the 
end  of  the  year  pays  a  dividend  of  $100,000,  the  work- 
ing capital  has  been  impaired  by  $50,000.  Fixed  capi- 
tal has  been  increased  and  sooner  or  later  additional 
fresh  working  capital  is  almost  certain  to  be  needed,  in 
order  to  keep  the  working  or  liquid  capital  of  the  con- 
cern up  to  its  normal  proportion  to  fixed.  Unless  the 
banker  is  careful  he  may  advance  funds  to  pay  divi- 
dends or  meet  withdrawals  by  partners  and  it  may 
turn  out  that  such  dividends  or  cash  withdrawals  are 
being  invested  in  another  or  other  enterprises  in  which 
the  borrower  has  a  greater  and  growing  interest.^ 

1  Cj.  Frederick  H.  Hurdman,  op.  cit.,  pp.  477,  478. 


THE  BANK  BORROWER'S  STATEMENT         207 

The  Borrower's  Capacity 

The  banker  scrutinizes  the  borrower's  statement  in 
order  to  discover  evidence  of  good  or  bad  management, 
and  natm-ally  enough  his  attention  is  directed  chiefly 
to  earnings.  Earnings  that  are  known  to  the  banker 
to  be  real  and  legitimate  over  a  long  period  constitute 
a  satisfying  index  of  capacity.  Where  this  criterion  is 
lacking,  owing  to  the  youthfulness  of  the  concern  or  to 
other  factors,  the  credit  expert  attempts  to  acquaint 
himself  with  the  technical  side  of  the  borrower's  busi- 
ness. If  the  borrower  is  known  to  be  lacking  in  a 
knowledge  of  the  technical  requirements  of  his  business 
or  weak  in  administrative  capacity  the  credit  risk  will 
be  clouded. 

The  cautious  banker  also  looks  well  into  the  charac- 
ter of  the  assets  of  the  borrower.  Clean  fresh  and 
salable  inventory  is  a  favorable  indication.  The 
mismanagement  that  causes  failure  is  nearly  always 
reflected  in  the  character  of  the  assets  of  the  bankrupt.^ 

The  information  that  the  banker  gains  concerning 
the  capacity  of  the  borrower  comes  in  part  from  reading 
between  the  lines  of  the  statement,  and  in  part  from 
independent  investigation.  The  interview,  where  that 
is  practicable,  is  also  of  value. 

From  what  has  been  said  in  this  chapter  and  the 
two  preceding,  three  main  facts  stand  out.  The  first 
is  that  the  banker  is  primarily  interested  in  the  ratio 
of  the  borrower's  quick  assets  to  his  current  liabilities. 
The  second  is  that  the  borrower's  net  worth  or  "capi- 

*  A.  C.  Foster,  Bank  Credits,  Bulletin,  American  Institute  of 
Banking,  Vol.  II,  p.  237. 


208  BANK  CREDIT 

tal,"  while  not  of  inimediate  interest  to  the  banker,  is 
nevertheless  of  vital  interest  to  him  inasmuch  as  he 
may  be  compelled  to  fall  back  upon  the  excess  of  assets, 
however  slow  they  may  be,  over  liabilities  in  the  event 
of  misjudgment  or  mishap.  The  third  is  that  if  state- 
ments over  a  considerable  period  show  reasonable  net 
profits,  provided  there  has  been  no  sudden  unexplained 
swelling  of  the  plant  account,  no  abnormal  increase  in 
the  merchandise  account  or  other  similarly  fictitious 
profitmaking  expedients,  the  presumption  is  highly 
favorable  to  safety.^  WTiether  a  borrower  does  or  does 
not  submit  a  statement,  the  banker  attempts  to  un- 
cover these  basic  facts  before  making  a  loan.  In  order 
to  do  so  he  does  not  rely  solely  on  the  borrower's  own 
written  or  oral  statement.  The  modern  banker  sup- 
plements and  verifies  or  disproves  the  contents  of  the 
borrower's  o^n  statement  by  an  investigation  the 
thoroughness  and  extent  of  which  would  frequently  be 
a  surprise  to  the  subject  investigated.  Even  many 
country  banks  are  now  building  up  credit  files,  the 
contents  of  which  are  in  part  traceable  to  the  direct 
investigation  efforts  of  the  country  banker  himself,  and 
in  part  to  the  Hberality  of  his  city  correspondents.  We 
shall  consider  in  the  next  chapter  the  nature  of  this 
supplementary  but  essential  and  illuminating  investi- 
gation of  the  borrower's  credit  worth.  It  is  in  place, 
however,  before  passing  on,  to  point  out  the  benefits 
of  rendering  a  statement  to  both  banker  and  borrow^er, 
and  the  significance  of  the  borrower's  refusal  to  render 
a  statement. 

1 C/.  H.  A.  Wheeler,  Credit  Information,  The  Financial  Age, 
Vol.  XXII,  No.  23,  November  14,  1910,  p.  1164. 


THE  BANK  BORROWER'S  STATEMENT         209 

Reciprocal  Benefits  of  Bank  Borrowers'  Statements 

The  interests  of  the  banker  and  his  borrowing 
customers  are,  or  should  be,  very  closely  allied;  what- 
ever benefits  the  borrower  benefits  the  banker  in  turn. 
The  direct  benefits  to  the  bank  of  the  practice  of 
borrowers  rendering  statements  are  obvious.  The 
indirect  benefits,  those  derived  through  the  improve- 
ment in  the  credit  risk  of  the  borrower  which  flows 
from  making  a  statement,  particularly  an  audited 
statement,  are  probably  equally  great.  The  benefits 
or  advantages  accruing  to  the  borrow^er  and  indirectly 
to  the  banker  as  the  result  of  rendering  periodical 
statements  may  be  stated  categorically. 

1.  The  very  fact  that  such  statements  are  to  be 
made  annually  and  submitted  to  one's  banker  doubt- 
less has  a  tendency  in  many  cases  to  cause  the  more 
ambitious  men  to  go  a  little  more  slowly  in  extending 
their  business  than  would  otherwise  be  true, — a  cir- 
cumstance that  tends  to  enhance  the  safety  of  the 
banker's  interests  and  at  the  same  time  save  the  bor- 
rower from  financial  distress,  if  not  failure.  Careful 
analysis  of  statements  is  beneficial  in  repressing  the 
too  buoyant  but  honest  optimism  of  some  concerns. 

2.  In  the  furnishing  of  credit  statements,  it  gives 
the  banker  a  good  understanding  of  what  borrowers  are 
doing,  and  makes  it  possible  for  him  to  give  advice  at 
times  which  may  be  helpful.  Even  though  one  may 
not  be  for  the  moment  a  borrower,  we  believe  it  well 
that  he  voluntarily  supply  his  banker  with  a  carefully 
prepared  financial  statement  of  his  condition,  for, 
added  to  the  benefit  which  would  probably  come  to 


210  BANK  CREDIT 

him  as  the  result  of  a  careful  study  of  the  details  of  his 
business  in  the  preparation  of  the  statement,  is  the 
decided  advantage  of  the  close  contact  and  relation- 
ship thus  estabUshed  between  the  two  parties.  Busi- 
ness men  are  being  inquired  about  constantly  as  to 
their  financial  responsibihty  by  other  men  in  business, 
and  the  banker  is  a  frequent  source  of  information. 

3.  In  order  to  make  a  statement  that  is  true  and 
correct  and  do  it  readily,  a  borrower's  accounts  must 
be  conducted  so  as  accurately,  plainly,  and  minutely 
to  set  forth  the  business  done  from  day  to  day,  and 
the  possession  of  such  a  record  is  of  great  assistance 
to  the  owner  or  manager  in  discovering  leaks,  or 
troubles  leading  to  losses.  Large  losses  are  often  sus- 
tained, especially  in  an  active  business,  because  of  the 
lack  of  knowledge  on  the  part  of  the  responsible  head 
of  the  details  of  his  business.  A  representative  of  a 
large  manufacturing  concern  once  said  that  "his  com- 
pany experienced  no  difficulty  in  competing  with  well- 
managed  companies,  who  fully  understood  their  busi- 
ness; the  most  vexatious  problems  being  competition 
with  those  manufacturers  who  kept  on  making  money 
until  they  reached  bankruptcy."^  The  banker  or 
credit  man  may  at  times,  in  analyzing  the  data  sub- 
mitted, perform,  in  a  measure,  an  auditor's  service  for 
the  borrower.  A  business  man  unfamiliar  with  ac- 
counting and  the  interpretation  of  accounting  facts 
may  be  disillusioned  by  his  banker.  Let  a  Detroit 
banker  give  us  a  concrete  illustration: 

1  R.  A.  Long,  Necessity  for  Credit  Statements  and  the  Desirability 
for  Uniformity  thereof,  Proceedings,  Forty-second  Annual  Conven- 
tion, American  Bankers'  Association,  1916,  p.  530. 


THE  BANK  BORROWER'S   STATEMENT         211 

A  customer  gave  his  report  to  us  in  January;  I  looked  it 
over,  compared  it  with  his  previous  statement,  and  he  ap- 
peared prosperous;  but  in  looking  it  over  more  carefully,  I 
discovered  a  greater  volume  of  business,  but  a  lesser  volume 
of  profit,  and  in  going  still  further  I  found  a  leak  apparently 
in  his  expense  account.  I  sent  for  him  and  .  .  .  said,  "Joe, 
you  don't  seem  to  have  done  very  well  last  j'^ear."  "Yes,  I 
did  a  good  business,  .  .  .  twice  as  much  as  last  year."  I 
said,  'You  didn't  make  as  much  money."  "Yes,"  he  said; 
but  upon  investigation  we  found  he  had  been  losing  money, 
by  the  old  bookkeeper.  We  finally  got  him  straightened  out, 
and  I  think  he  will  make  some  money  this  year,  and  that 
was  simply  because  I  cautioned  him.  He  was  not  paying 
close  enough  attention  to  his  business,  and  the  old  statement 
he  filed  with  us  was  really  valuable  to  him  and  valuable  to  us 
in  showing  the  condition  of  his  credit. 

When  a  borrower  complies  with  the  request  of  his 
bank  for  a  statement  it  frequently  gives  him  an  in- 
terest in  his  affairs  that  he  never  had  before.  He 
takes  pride  in  rendering  another  statement  the  next 
year,  particularly  if  he  is  prospering  and  is  the  right 
kind  of  a  borrower.^ 

Significance  of  Refusal  to  Render  Statement 

Some  firms  dealing  with  even  city  banks  do  not 
make  statements  from  fear  that  their  actual  condition 
would  become  known  and  be  a  disappointment  to  those 
who  consider  their  position  and  business  to  be  better 
than  it  actually  is.    On  the  other  hand,  the  fear  may 

1  W.  S.  Weston,  The  Credit  Department  of  a  Country  Bank,  Pro- 
ceedings, Sixteenth  Annual  Convention,  Nebraska  Bankers'  Asso- 
ciation, 1912,  p.  34. 


212  BANK  CREDIT 

be  that  their  condition  would  be  found  too  prosperous 
and  in\dte  others  to  enter  the  business  and  compete. 
In  these  instances  there  is  no  defined  rule  to  be  laid 
down  as  to  the  extension  of  credit.  All  the  circum- 
stances must  be  taken  into  consideration  and  the  case 
decided  on  its  merits.  It  is  the  testimony  of  an  ex- 
perienced New  York  banker  that  more  often,  when  a 
man  refuses  to  make  a  statement,  it  is  because  he  dare 
not  rather  than  from  fear  of  showing  too  much  pros- 
perity.^ 

There  are,  however,  many  cases  where  some  of  the 
best  concerns  in  the  market  have  never  made  and 
never  will  make  statements  of  their  affairs.  Some  of 
the  choicest  names  in  the  New  York  market  whose 
paper  the  banks  do  not  hesitate  to  buy  in  large  amounts, 
or  to  discount  liberally,  are  those  of  concerns  that 
refuse  to  make  even  so  much  as  a  statement  of  the 
amount  of  capital  invested.  They  are,  nevertheless, 
known  as  very  reliable  and  able  concerns  that  have 
been  in  business  for  many  years.  Their  names  stand 
for  integrity  and  honor;  their  methods  are  believed  to 
be  sound  and  correct." 

In  general  it  is  the  safer  practice  for  the  banker  to 
avoid  the  glamour  of  great  names  and  great  concerns 
that  refuse  to  exhibit  a  condition  of  their  affairs.  A 
concern  that  is  financially  strong  will  almost  invariably 

1  Robert  A.  Parker,  Practical  Credit,  Bulletin,  American  Institute 
of  Bank  Clerks,  Vol.  VI,  p.  353. 

2  Joseph  B.  Martindale,  The  Business  of  a  Commercial  Bank  and 
How  to  Sagejuard  the  Investment  of  Its  Funds,  Proceedings,  Thirty- 
seventh  Annual  Convention,  American  Bankers'  Association,  1911, 
p.  702. 


THE  BANK  BORROWER'S  STATEMENT         213 

court  investigation.^  WTiere  an  applicant  for  a  loan 
refuses  to  make  a  statement  or  give  credit  information 
the  way  in  which  the  refusal  is  made  may  be  a  clear 
indication  of  his  condition. 

1  Lowrie  C.  Blanding,  The  Study  of  Commercial  Credits,  Proceed- 
ings, Eleventh  Annual  Meeting,  Iowa  Bankers'  Association,  1897, 
p.  38. 


CHAPTER  XI 

Investigating  the  Credit  Risk 

As  we  have  observed,  the  puipose  of  the  banker  in 
asking  the  borrower  to  submit  a  statement,  whatever 
form  that  statement  may  take,  is  to  discover  the  truth 
concerning  the  business  condition  of  the  appHcant 
for  credit.  The  measure  of  truth  revealed  by  a  state- 
ment depends  upon  several  factors.  If  the  borrower  is 
honest  and  has  good  judgment  of  values  in  his  business 
his  statement  is  valuable.  If  he  has  bad  judgment 
even  honesty  and  veracity  lose  their  force.  If  he 
has  neither  honesty  nor  good  judgment  his  statement 
is  valueless.  Where  honesty  and  good  judgment  of 
values  are  coupled  with  adequate  accounting  machin- 
ery even  the  uncertified  statement  of  the  borrower  may 
be  looked  upon  as  a  sound  basis  of  credit  negotiation. 
Such  a  borrower,  thoroughly  understanding  his  own 
affairs,  relieves  the  banker  of  much  responsibihty. 
Danger  is  sighted  in  time  to  prevent  loss  to  borrowed 
capital. 

But  the  banker  never  knows  without  investigation 
whether  the  borrower's  oral  or  written  statement  is 
true  or  false,  or,  better  perhaps,  to  what  extent  it  is 
true  and  false.  The  task  of  the  banker  is  to  find  the 
facts  concerning  the  borrower's  affairs  and  character 
and  then  from  those  facts  reach  a  sound  conclusion  as 
to  the  payment  or  non-payment  of  the  amount  which 
the  borrower  hopes  to  obtain.     Accordingly  an  effort 

214 


INVESTIGATING  THE  CREDIT  RISK  215 

is  made,  through  tapping  a  large  number  of  sources  of 

information,  to  supplement  and  to  test  the  borrower's 
estimate  of  himself,  an  estimate  that  experience  has 
generally  shown  to  be  too  high. 

Handbooks  as  a  Source  of  Information 

Banks  having  large  and  active  credit  departments 
utilize  trade  reference  works,  which  are  valuable  in 
''routing"  investigations  as  well  as  for  the  information 
they  contain.  The  Textile  Trade  Directory,  for  ex- 
ample, contains  the  names  of  most,  if  not  all,  of  the 
manufacturers  of  textiles  in  the  United  States  together 
with  a  brief  description  of  the  property,  names  of  offi- 
cers, a  list  of  concerns  handling  raw  materials  used  by 
the  manufacturers,  and  the  names  of  wholesalers  and 
jobbers  throughout  the  country.  Corresponding  hand- 
books for  other  trades  are  used  in  a  similar  way. 
Among  such  books  the  bank  directory  also  has  a 
prominent  place. 

The  Mercantile  Agencies 

Every  bank  of  importance  is  a  subscriber  to  Dun's 
and  Bradstreet's.  The  rating  books  of  these  mercan- 
tile agencies  and  their  special  reports,  although  in- 
adequate and  not  always  in  accord  with  the  facts,  are 
of  more  than  merely  confirmative  value.  The  agency 
reports  frequently  throw  flashes  of  light  on  the  charac- 
ter of  the  management,  giving  facts  as  to  age,  fires — 
not  unimportant,— litigation,  and  failures,  and  may 
throw  out  hints  as  to  methods  of  pay.^ 

1  F.  W.  Crane,  Commercial  Paper  Purchased  from  Brokers,  Pro- 
ceedings, Thirty-sixth  Annual  Convention,  Illinois  Bankers'  Asso- 
ciation, 1916,  p.  135. 


216  BANK  CREDIT 

The  Trade 

Probably  the  most  important  single  source  of 
information  for  the  banker  is  the  ''trade."  Checks 
and  drafts  passing  through  the  bank  give  the  names  of 
houses  with  which  the  depositor  deals  and  these  houses 
are  a  som"ce  of  information  as  to  how  accounts  for 
merchandise  are  taken  care  of.^  As  the  ''trade"  is  one 
of  the  main  sources  of  credit  information,  it  foUow^s 
that  a  great  commercial  center  like  New  York  w^ould 
afford  superior  information  facihties  and  possibihties. 

Even  the  class  of  firms  from  whom  goods  are  bought 
is  an  excellent  index  of  the  credit  standing  of  the  buyer. 
A  poor  credit  risk  may  possibly  do  business  with  one 
or  two  first-class  houses,  but  it  will  be  difficult  to  do 
business  wdth  a  half  dozen  or  dozen  houses  of  a  high 
order,  as  houses  that  investigate  the  credit  standing  of 
their  customers  are  not  hkely  to  sell  to  those  of  doubt- 
ful reputation.  In  other  words,  if  a  dozen  mercantile 
credit  men  pass  favorably  upon  the  subject  after 
looking  him  up  thoroughly,  the  chances  of  all  being  led 
astray  are  very  remote.  Consequently  the  applicant 
for  a  loan  who  deals  in  the  regular  way  with  a  number 
of  first-class  houses  has  that  circumstance  distinctly 
in  his  favor.  2 

Mercantile  credit  men  are  generally  very  willing 
to  answer  the  questions  of  the  outside  man  represent- 
ing the  bank.    To  an  experienced  credit  man  the  ques- 

1  S.  R.  Flynn,  A  Tvjentieth  Century  Credit  System,  Proceedings, 
Thirteenth  Annual  Convention,  Michigan  Bankers'  Association, 
1901,  p.  31. 

2  J.  G.  Cannon,  Credit,  Credit-Man,  Creditor,  Bankers'  Magazine, 
Vol.  LIII,  July,  1896,  p.  39. 


INVESTIGATING  THE  CREDIT  RISK  217 

tions  of  the  bank  man  are  of  great  value.  He  often 
wants  to  know  from  what  source  they  emanate  and 
precisely  why  they  are  made.  The  mercantile  credit 
man  may  often  receive  more  information  than  he  im- 
parts.^ ''Scanty  fare  for  one  will  ofttimes  make  a 
royal  feast  for  two."  Both  bank  and  mercantile  credit 
men  do  not  regard  their  knowledge  and  ideas  as  their 
own  indi\'idual  property.  Of  course  information 
given  a  bank  by  a  borrowing  customer  is  generally 
treated  by  the  bank  in  a  reasonably  confidential  man- 
ner. 

The  credit  man  and  the  outside  men  should  be 
good  investigators,  capable  of  asking  the  right  ques- 
tions. In  illustration  of  this  point  may  be  mentioned 
a  case  where  a  credit  man  called  upon  the  head  of  a 
firm  to  secure  information  regarding  a  certain  concern. 
When  asked  if  he  sold  to  this  concern,  the  head  of  the 
firm  being  interviewed  replied,  ''Without  limit." 
It  occurred  to  the  inquirer  that  it  might  be  advisable 
to  ask  the  terms  upon  which  the  goods  were  sold,  and 
the  response  was,  "Always  for  cash." 

The  successful  credit  investigator  is  a  patient  in- 
quirer, always  preferring  to  wait  rather  than  interrupt. 
Having  secured  an  audience  with  the  credit  man  or  the 
person  attending  to  the  credit  of  the  house,  the  inves- 
tigator will  tactfully  ask  such  leading  questions  as : 

Do  they  pay  their  bills  promptly? 

For  what  length  of  time  do  you  give  them  credit? 

How  long  have  you  been  selling  to  them  and  do  they 
buy  largely  from  your  house? 

Do  you  think  their  expenses  are  heavy? 

I  Ibid. 


218  BANK  CREDIT 

Do  you  think  they  are  making  money? 

Have  you  heard  anything  said  about  their  respon- 
sibihty  or  character? 

It  need  scarcely  be  said  that  the  investigator  will 
not  be  satisfied  with  equivocal  or  fragmentary  infor- 
mation and  a  considerable  number  of  inquiries  may 
have  to  be  made  before  convincing  and  decisive  facts 
are  got.  The  credit  man  wants  to  know  whether  the 
statement  tells  the  truth  and  accordingly  presses  to  the 
fore  his  inquiries  concerning  the  moral  hazard. 

The  trade  expert  plays  a  role  in  connection  with  the 
work  of  the  bank  credit  man  that  has  not  been  appre- 
ciated fully.  The  credit  man  of  the  bank  goes  to  a  cer- 
tain point  in  the  analysis,  applying  the  principles  with 
which  he  works  familiarly  and  then  turns  to  his  trade 
acquaintances  for  information  that  constitutes  the  fin- 
ishing touches — to  men  who  have  made  a  life  study  of 
the  particular  line  and  whose ''  sensitive  finger-tips  are  at 
aU  times  upon  the  pulse  of  trade  forces."  The  banker's 
field  of  necessity  covers  such  a  wide  range  in  credits 
that  he  cannot  apply  the  closest  tests  based  on  daily 
or  weekly  advices  coming  to  the  trade  specialist,  whose 
channels  of  information  have  been  built  up  and  pre- 
served with  the  utmost  care  through  a  period  of  years. 

One  of  the  trade  opinions  that  the  banker  has  learned 
to  prize  highly  is  that  of  the  mercantile  expert  who  sits 
at  the  table  in  the  board  room  of  the  bank.  This  man 
has  a  dual  responsibility  which  he  quickly  measures. 
He  knows  whether  it  would  be  advisable  to  extend  a 
merchandise  credit  when  he  is  reasonably  sure  the 
account  would  be  discounted  and  the  profit  a  good  one, 
and  he  also  knows  whether  to  recommend  the  concern's 


INVESTIGATING  THE  CREDIT  RISK  219 

note  for  discount  at  his  bank  on  long  time  and  at  a  low 
rate.    He  may  favor  one  and  oppose  the  other.  ^ 

Bankers  sometimes  inquire  for  information,  in  the 
ease  of  paper  offered  by  brokers,  directly  of  the  con- 
cern the  purchase  of  whose  notes  is  under  considera- 
tion. Such  inquiries,  whether  concerning  mortgage 
debt  or  some  other  matter,  may  be  intended  only  as 
"feelers,"  and  to  satisfy  curiosity  as  to  what  manner  of 
men  the  makers  are.- 

Banks 

Banks  are  also  an  important  source  of  credit  infor- 
mation. Hour  after  hour  investigators  from  other 
banks  call  to  make  inquiry  regarding  customers  or 
concerns  in  whose  paper  correspondents  of  the  inquir- 
ing banks  are  interested.  Although  the  calling  of 
investigators  is  an  interruption,  an  opportunity  is 
afforded  to  the  banker  to  whom  the  inquirer  comes  for 
comparing  notes  and  the  ''inquiree"  may  receive  the 
benefit  of  information  coming  through  channels  that 
might  otherwise  be  closed. 

The  replies  of  bankers  to  inquirers  concerning  the 
financial  standing  and  character  of  their  fellow  towns- 
men can  not  always  be  relied  upon  implicitly,  although 
bankers  as  a  rule  are  thoroughly  honest  with  one 
another;  bad  judgment  may  at  times  creep  in  and, 
very  rarely,  intentional  misrepresentation.^  Four  of 
the  leading  bankers  in  a  leading  city  reported  that  a 

*  William  Post,  A  Ten-Minute  Ramble  in  Credits,  Bulletin,  Amer- 
ican Institute  of  Bank  Clerks,  Vol.  VI,  p.  254. 

*  Idem,  The  Loan  and  Credit  Department,  Bulletin,  Americfin 
Institute  of  Bank  Clerks,  Vol.  Ill,  p.  167. 

»  Cf.  S.  R.  Flynn,  op.  cit.,  pp.  32,  33. 


220  BANK  CREDIT 

certain  manufacturing  concern  had  good  local  credit 
standing.  At  that  time  each  of  the  four  bankers  was 
carrying  the  paper  of  the  concern  and  knew  that  it  was 
not  ''an  available  asset."  Subsequently, — perhaps 
after  the  bankers  had  sloughed  off  some  of  their  own 
holdings, — losses  on  this  paper  were  hea\y. 

The  problem  of  the  credit  manager  is  to  get  an  opin- 
ion of  the  maker  of  the  paper  from  a  banker  who  knows 
the  risk  at  first  hand,  and  this  is  not  always  an  easy 
matter.  If  the  maker  of  a  note  does  business  in  Seattle 
and  information  concerning  him  comes  from  Phila- 
delphia \'ia  Chicago  and  San  Francisco,  it  may  be 
garbled,  being  an  indirect  quotation,  generally  tinc- 
tured by  the  minds  through  which  it  has  passed. 
Some  banks  attempt  to  protect  themselves  by  means  of 
a  system  of  triple  or  quadruple  checking  through 
additional  centers.  Even  then  it  may  happen,  how- 
ever, that  all  the  intermediaries  are  relying  on  one 
primary  source,  and  the  result  may  be,  in  essence,  a 
single  opinion.^  Nevertheless,  banks,  especially  cor- 
respondent banks,  are  storehouses  of  information  that 
is  scarcely  available  elsewhere. 

Any  surprise  that  banks  should  go  to  great  lengths 
to  secure  credit  information  for  their  correspondents 
and  in  many  instances  for  their  competitors  is  quickly 
dissipated  when  it  is  recalled  that  in  serving  others, 
they  serve  themselves.  Fresh  information  obtained  is 
carefully  recorded  for  possible  future  use,  before  it  is 
transmitted  to  inquiring  banks.  Furthermore,  an 
inquiring  bank  is  a  possible  source  of  information  and 

1  F.  B.  Snyder,  Credit  Service,  Bankers'  Magazine  (New  York), 
Vol.  88,  May,  1913,  p.  557„ 


INVESTIGATING  THE  CREDIT  RISK  221 

the  cultivation  of  cordial  relations  is  of  mutual  impor- 
tance and  advantage.^ 

The  Interview 

The  banker  who  is  able  to  interview  his  borrowing 
customers  has  a  decided  advantage.  The  bank  officer 
who  interviews  applicants  for  credit  ought  to  be  a  good 
judge  of  faces  and  character,  and  to  the  extent  that  the 
countenance  is  the  index  of  the  heart,  the  officer  may 
be  able  to  tell  whether  the  applicant  is  telling  the  truth. 
Mr.  J.  G.  Cannon  used  to  contend  that  a  great  many 
people  talked  to  the  bank  officer  or  credit  manager 
without  coming  down  to  facts.  ^ 

The  interview  affords  the  banker  an  opportunity 
to  find  out  in  an  indirect  way  the  borrower's  notion  of 
what  constitutes  honesty.  Another  point  that  com- 
mands attention  is  the  circumstances  under  which  the 
borrower  started  business  life.  It  should  make  a  dif- 
ference whether  the  borrower's  money  was  made  by  his 
own  efforts  or  came  to  him  through  the  assistance  of 
friends  or  relatives,  or  through  inheritance.^  What 
has  come  by  dint  of  hard  work  is  less  likely  to  be 
squandered  or  lost  through  reckless  management  than 
funds  acquired  without  effort. 

There  is  little  doubt  that  the  borrower's  personality 
has  a  distinct  bearing  upon  the  decision  of  the  bank 
officer  when  he  says  "yes"  or  "no".  Hence  it  is  desir- 
able to  scrutinize  the  figures  presented  by  the  borrower 

1  William  Post,  Bulletin,  American  Institute  of  Bank  Clerks, 
Vol.  Ill,  p.  168. 

*  J.  G.  Cannon,  Credit,  Credit-Man,  Creditor,  Bankers'  Magazine 
(New  York),  Vol.  53,  July,  1896,  p.  37. 

^Ibid. 


222  BANK  CREDIT 

and  come  to  a  conclusion  from  an  analytical  as  well  as 
from  a  personal  standpoint.  Some  of  the  best  talkers 
and  some  of  the  most  attractive  personalities  are 
among  the  poorest  business  men.^  Accordingly,  when 
the  banker  feels  the  personal  influence  or  persuasive 
power  of  a  prospective  borrower,  let  him  invoke  the 
purely  impersonal  and  cold-blooded  analysis. 

A  banker  may  easily  reach  a  conclusion  concerning 
extending  credit  before  the  matter  of  figures  is  reached. 
From  brief  conversation  the  banker  may  make  up  his 
mind:  "This  is  a  man  I  don't  want  to  have  anything  to 
do  with."  The  banker  should  rely  upon  his  intuition 
under  those  conditions,  says  Mr.  James  B.  Forgan,  and 
should  not  let  ''mathematics  or  science  or  theory  or 
anything  else  change  his  mind."^ 

The  Method  of  Investigation  in  a  Particular  Case 

We  may  now  profitably  consider  the  way  in  which 
the  credit  standing  of  a  given  concern  is  investigated. 
Take  a  shoe  manufacturing  concern  located  at  Hunt- 
ington, Indiana.  The  concern  has  opened  an  account, 
let  us  say,  with  the  Mechanics  and  Metals  National 
Bank  of  New  York,  and  has  applied  for  a  loan.  The 
first  step  might  well  be  to  secure  a  report  from  Brad- 
street's  or  R.  G.  Dun  and  Company,  which  would 
contain  a  brief  record  of  the  company.  Then  the  New 
York  bank  would  inquire  of  bankers  in  Huntington, 

1  Joseph  B.  Martindale,  The  Business  of  a  Commercial  Bank  and 
how  to  Safeguard  the  Investment  of  its  Funds,  Proceedings,  Thirty- 
seventh  Annual  Convention,  American  Bankers'  Association,  1911, 
p.  699. 

2  James  B.  Forgan,  Proceedings,  Twenty-Third  Annual  Conven- 
tion, Michigan  Bankers'  Association,  1909,  p.  57, 


INVESTIGATING  THE  CREDIT  RISK  223 

with  whom  the  concern  would  also,  almost  of  necessity, 
maintain  an  accoimt.  Inquiries  would  also  be  ad- 
dressed to  banking  connections  that  the  concern  might 
have  in  other  cities.  The  New  York  bank  would  also 
communicate  with  banking  friends,  from  whom  close 
information  might  be  obtainable,  in  Indianapolis, 
Toledo,  perhaps  Cincinnati  and  St.  Louis. 

The  Mechanics  and  Metals  National  Bank  would 
also  have  friends  in  the  leather  trade  in  Chicago  and 
elsewhere  to  whom  inquiries  would  be  sent.  Letters 
might  also  be  sent  to  certain  competing  shoe  manu- 
facturers in  order  to  ascertain  the  quality  of  the  con- 
cern's product,  the  demand  for  it,  and  perhaps  certain 
facts  as  to  production  and  selling  methods.  If  the 
Huntington  concern  bought  raw  materials  and  supplies 
in  New  York,  the  bank's  investigators  would  canvass 
the  houses  selling  the  subject  company. 

The  closest  investigations  are  made  m  connection 
with  new  accounts  and,  as  in  this  case,  when  oppor- 
tunity for  an  interview  may  be  lacking.  Not  infre- 
quently, however,  the  credit  man  or  bank  officer  will 
buy  a  ticket,  take  a  train,  and  make  a  careful  investi- 
gation of  the  personnel  and  plant  of  the  concern 
applying  for  a  heavy  initial  loan. 

In  addition  to  gathering  facts  on  the  given  name 
under  consideration  the  investigators,  interviewing 
wholesalers,  jobbers,  manufacturers  and  others,  also 
collect  valuable  information  relative  to  general  busi- 
ness conditions  underlying  each  trade.  Through  this 
information  concerning  the  trade  and  business  outlook, 
the  credit  man  is  better  able  to  appraise  the  credit 
deserts  of  the  borrowing  customer. 


CHAPTER  XII 

Secured  Loans 

The  principal  kinds  of  secured  loans  made  by  our 
banks  are  those  coUateralled  by  stocks  or  bonds,  those 
secured  by  warehouse  receipts,  and  those  backed  by 
mortgages.  The  volimae  of  our  secured  bank  loans  in 
comparison  with  those  represented  by  paper  unsup- 
ported by  valuables  pledged  as  security  was  brought 
out  in  a  previous  chapter.  It  will  be  in  place  now  to 
present  some  of  the  aspects  of  the  three  classes  of  loans 
mentioned. 

The  problems  of  the  banker  in  connection  with 
secured  loans,  particularly  those  secured  by  stocks 
and  bonds  are,  by  contrast  with  the  exhaustive  inves- 
tigation and  analysis  carried  out  as  a  preliminary  to 
lending  on  unsecured  paper,  comparatively  simple. 
His  main  concern  is  to  see  that  the  security  taken  has 
ample  value.  The  important  question  that  confronts 
the  banker  bears  upon  the  value  of  the  stocks  or  bonds 
offered  as  collateral. 

New  York  bankers  in  making  loans  to  brokers  pay 
relatively  little  attention  to  the  character  or  normal 
value  of  the  collateral,  but  rely  chiefly  upon  its  value 
in  the  market.  If  there  is  an  active  market  for  a  stock 
— New  York,  New  Haven  and  Hartford,  for  example, 
which  is  now  selling  around  30 — banks  accept  it  as 
collateral  almost  as  readily  as  a  stock  like  Union 
Pacific,  which  is  selling  near   130.     Elsewhere,  in  a 

224 


SECURED  LOANS  225 

place  like  Baltimore,  for  instance,  and  among  the 
country  banks,  the  collateral  value  of  a  security  is 
gauged  by  what  the  banker  considers  its  "intrinsic" 
value.  New  York  bankers  are  chiefly  concerned  with 
the  resiliency  of  the  market, — whether  suddenly  throw- 
ing large  blocks  of  the  given  security  on  the  market 
would  leave  it  in  a  depressed  state.  ^  Bankers  outside 
of  the  metropolis  are  more  deeply  interested  in  the 
wholesome  character  of  security  offered  as  collateral. 
The  common  stock  of  a  prosperous  Denver  enterprise 
might  be  highly  regarded  as  collateral  by  local  bankers, 
but  unacceptable  to  Wall  Street  banks.  On  the  other 
hand,  the  first  mortgage  bonds  of  a  great  railway  sys- 
tem which  was  in  the  hands  of  a  receiver,  but  for  the 
securities  of  which  a  broad  and  active  market  existed 
on  the  New  York  Stock  Exchange,  might  readily  be 
taken  as  collateral  by  the  New  York  banker  and  looked 
askance  at  by  the  banker  in  Denver. 

It  is  a  sound  practice  for  bankers  making  collateral 
loans  to  insist  upon  full  security  because  of  the  treat- 
ment accorded  the  collateral  loan  in  the  bankniptcy 
courts  and  the  legal  technicalities  and  delays  incident 
to  realizing  on  this  variety  of  loan  in  many  states.^ 
The  margin  required  ought  always  of  course  to  be 
sufficient  to  throw  the  burden  of  value  fluctuation  on 
the  shoulders  of  the  borrower. 

Because  of  the  absence  of  value  fluctuation  life  in- 

1  John  M.  Nelson,  Securities  and  Investments,  Bulletin,  American 
Institute  of  Banking,  Vol.  II,  p.  477. 

2  Edgar  H.  Sensenich,  Some  Well  Founded  Principles  of  Banking, 
Proceedings,  Twenty-First  Convention,  California  Bankers'  Asso- 
ciation, 1915,  p.  141. 


226  BANK  CREDIT 

surance  policies  are  superior  to  stocks  and  bonds  as 
security  for  loans.  Such  policies,  it  has  long  been 
recognized,  are  worth  as  collateral  security  whatever 
their  cash  surrender  value  may  be,  and  they  are  freely 
accepted  by  banks  as  good  collateral  on  satisfactory 
assignment.  The  surrender  value  is  commonly  stated 
in  plain  terms  in  the  body  of  the  policy.^  Life  insur- 
ance policies  are  a  liquid  security  even  in  times  of 
severe  monetary  stringency.^ 

Warehouse  Loans 

Of  the  vast  streams  of  produce,  merchandise,  and 
manufactured  wares  of  the  country  a  certain  propor- 
tion representing  the  surplus  of  the  time  finds  its  way 
into  warehouses  and  cold  storage  establishments, 
where  it  rests  until  demand  starts  it  again  on  its  way  to 
consumers.  The  banking  practice  of  assisting  mer- 
chants and  traders  to  carry  large  stocks  of  grain  and 
other  goods  when  represented  by  warehouse  receipts 
or  bills  of  lading  probably  originated  with  the  Com 
Exchange  Bank  of  New  York.^ 

Mr.  Dunham,  the  first  president  of  that  institution, 
whose  familiarity  with  the  grain  trade  led  to  the  intro- 
duction of  lending  on  warehouse  receipts,  used  to  say 
that  such  staples  as  wheat  and  cotton,  wool  and  pork, 
coffee  and  lard  were  as  good  as  gold  and  that  he  was 

1  William  T.  Gage,  Life  Insurance  as  Collateral,  Proceedings, 
Twenty-seventh  Annual  Convention,  Michigan  Bankers'  Associa- 
tion, 1913,  p.  128. 

'^  Wilham  Livingston,  Proceedings,  Twenty-Seventh  Annual  Con- 
vention, Michigan  Bankers'  Association,  1913,  pp.  132,  133. 

2  Albert  M.  Read,  Warehouse  Receipts  as  Bankable  Paper,  Bulletin, 
American  Institute  of  Bank  Clerks,  Vol.  V,  p.  5. 


SECURED  LOANS  227 

willing  to  lend  gold  on  the  pledge  of  these  commodities 
as  security.  Preference  for  these  staples  as  security 
has  generally  given  way  so  that  at  present  and  for 
many  years  past  warehouse  loans  have  been  made  in 
less  desirable  lines  of  trade,  where  the  solidity  of  the 
borrower  has  offset  the  disadvantage  of  his  collateral. 
Grain  in  elevators,  whiskey  and  tobacco  in  the  general 
revenue  bonded  stores,  silks  and  tea  in  the  customs 
bonded  warehouses,  cotton  in  the  ginneries,  eggs, 
butter  and  apples  in  cold  storage,  citrus  fruits,  raisins, 
nuts,  vegetables,  fish,  furs,  wool,  cloth,  clothing,  car- 
pets, rugs  and  rubber  tires, — these  suggest  the  ex- 
traordinary expansion  of  the  list  of  commodities  now 
pledged  as  seciu-ity  for  bank  loans. 

Several  factors  influence  the  safety  of  loans  on  ware- 
house receipts;  the  most  important  being  the  character 
and  responsibility  of  the  warehouseman,  the  financial 
responsibility  of  the  borrower  and  the  value  of  the 
goods  represented  by  the  receipts.  Although  the 
warehouseman  can  not  be  held  legally  responsible  for 
contents  of  cases,  as  to  either  quality  or  quantity,  nor 
for  ownership  of  goods  in  the  borrower,  he  is  required 
by  law  to  exercise  ordinary  care,  i.  e.,  that  degree  of 
care  which  men  of  prudence  exert  under  similar  cir- 
cumstances with  regard  to  their  own  property,  in  the 
safe-keeping  of  goods  called  for  by  receipts  issued.  He 
may  be  held  responsible  also  for  the  fraudulent  issue  of 
receipts,  as  in  the  case  of  the  issue  of  two  or  more  re- 
ceipts for  the  same  goods  as  well  as  in  the  case  of 
making  any  statement  calculated  to  deceive.  If  to  the 
solidity  and  responsibility  of  the  warehouseman  and 
the  borrower  and  a  determination  of  the  quantity, 


228  BANK  CREDIT 

quality  and  value  of  the  goods  by  a  trustworthy  ex- 
pert, we  add  carefulness  and  watchfulness  as  to  chang- 
ing values  and  markets,  insurance,  duties,  etc.,  we 
have  in  mind  by  far  the  most  weighty  considerations 
affecting  the  safety  of  this  growing  class  of  loans,  ^ 

The  commodity  stored,  the  warehouseman,  and  the 
borrower  himself, — in  all  three  the  banker,  then,  has  an 
interest.  Through  experience  bankers  have  become 
unwilhng  to  loan  on  commodities  stored,  irrespective 
of  the  character  and  credit  worth  of  the  borrower  and 
of  the  warehouseman.  If  the  banker  furnishes  funds  to 
enable  producers  or  manufacturers  or  merchants  to 
put  their  products  or  goods  in  warehouse  he  may  there- 
by become  essentially  the  purchaser  of  merchandise 
otherwise  unsalable.  If  a  full  knowledge  of  the  goods 
is  not  in  the  possession  of  the  banker  they  may  deter- 
iorate or  become  unsalable  seasonally.^  Many  com- 
modities, including  cotton,  are  subject,  however,  to 
Uttle  or  no  deterioration.  Under  reasonably  good 
storage  conditions  baled  cotton  will  keep  unimpaired 
ten  years  or  longer.  Instances  have  been  known  where, 
after  being  stored  in  a  farmer's  barn  fifteen  years,  it 
brought  the  current  market  price.  ^ 

Grain  receipts  are  used  extensively  as  collateral  for 
loans  to  finance  the  stocks  of  grain  carried  in  elevators 

1  Ibid.,  p.  7. 

2  F.  L.  Lipman,  Rediscounts  under  the  Federal  Reserve  Act,  Pro- 
ceedings, Twentieth  Annual  Convention,  California  Bankers'  Asso- 
ciation, 1914,  pp.  85,  86. 

» Charles  J.  Haden,  A  Plea  for  the  Cotton  Fields,  Proceedings, 
Thirty-second  Annual  Convention,  American  Bankers'  Association, 
St.  Louis,  1906,  p.  128. 


SECURED  LOANS  229 

during  the  movement  of  the  crop.  When  the  receipts 
are  pledged  as  collateral  the  borrower  is  expected  to 
maintain  the  value  of  the  security  at  ten  per  cent  above 
the  face  of  the  loan.  Rigid  inspection,  weighing,  and 
storing  practices  have  caused  the  receipts  to  be  re- 
garded as  thoroughly  sound  collateral. 

Cotton  Loans 

As  soon  as  cotton  has  been  picked  and  ginned  it 
becomes  highly  acceptable  as  security  and  the  banker 
may  advance  money  to  buyers  to  enable  them  to  carry 
on  their  business.  According  to  the  usual  method  of 
lending  to  the  cotton  buyer  or  broker  the  banker  re- 
quiries  a  cash  deposit  or  other  acceptable  security  at 
the  beginning  of  the  season  adequate  to  protect  the 
bank  against  loss  from  market  fluctuation.  The  bank, 
retaining  a  safe  margin  as  protection  against  loss  from  a 
sudden  decline  in  the  market  price,  advances  a  stipu- 
lated sum  against  each  bale.  The  buyer,  of  course,  has 
to  sell  as  the  season  advances,  or  else,  if  an  extensive 
operator,  he  would  consume  his  margin  in  purchasing 
new  cotton.  The  customary  margin  required  is  $5  per 
bale  when  cotton  is  selling  at  six  cents  per  pound  or 
below;  $10  when  selling  at  seven,  eight,  or  nine  cents; 
$15  when  selling  from  ten  to  twelve  cents,  the  same 
changing  proportion  obtaining  as  the  price  goes  higher.^ 

In  making  the  majority  of  these  loans  on  cotton  the 
banks  take  over  order  bills  of  lading,  endorsed  by  the 
shipper  and  generally  covering  shipments  to  buyers  in 
care  of  a    compress  or  warehouse  that  receives,  com- 

*  R.  H.  Thompson,  Cotton  Loans,  Bulletin,  American  Institute  of 
Bajik  Clerks,  August  1,  1905,  p.  261. 


230  BANK  CREDIT 

presses  and  stores  for  future  delivery  to  spinners  or  for 
export.  The  compress,  upon  getting  possession  of  the 
cotton,  issues  warehouse  receipts  in  the  name  of  the 
consignee  in  individual  lots,  marked  and  numbered  to 
correspond  to  the  tags  and  marks  on  each  bale  of 
cotton.  The  receipts  are  then  given  to  the  bankers  in 
lieu  of  the  bill  of  lading  surrendered.  The  system  of 
using  receipts  in  one  bale  lots  enables  the  banks  al- 
ways to  claim  the  exact  bales  on  which  advances  have 
been  made,  should  the  lending  institution  be  compelled 
to  take  possession  of  the  cotton  pledged  as  security. 
This  system  of  receipts  based  on  one-bale  lots  also 
affords  protection  against  the  substitution  of  one  grade 
for  another  and  reduces  the  possibihty  of  forged  re- 
ceipts.^ 

Crop  Loans 

Loans  on  growing  crops  may  safely  be  made  as  a 
rule  only  when  the  crops  are  nearing  maturity.  Loans 
made  solely  on  crops  are  very  insecure,  owing  to  the 
likelihood  of  failure.  Bankers  often  advance  the 
cotton  grower  funds  with  which  to  begin  his  crop, 
taking  a  chattel  mortgage  and  usually  including  in 
the  mortgage  all  other  chattels  that  are  a  part  and 
parcel  of  the  farm.  This  additional  security  is  de- 
manded because  the  crop  may  be  struck  by  drouth, 
flood,  or  other  disaster  unforeseen. 

The  banker  can  confer  benefit  on  the  'Aground 
skinner"  and  exclusive  cotton  or  wheat  grower  and  at 
the  same  time  increase  the  safety  of  his  own  interests 
by  insisting  that  a  considerable  proportion,  one  half, 

^Ibid. 


SECURED  LOANS  231 

let  us  say,  of  all  loans  made  by  the  bank  be  invested  in 
other  lines  of  farming.  The  man  with  cattle  and  a  silo, 
some  hogs  and  brood  mares,  need  not  be  feared  when 
borrowing  to  put  out  cotton,  wheat  or  other  crop.^ 

Loans  to  farmers  on  cotton  as  sole  security  should 
not  exceed  60  or  65  per  cent  of  the  value  of  the  cotton. 
This  percentage  is  a  protection  to  both  the  banker  and 
the  farmer  against  the  loan  being  called  when  the  price 
is  fluctuating.  The  farmer  who  has  to  borrow  in  excess 
of  60  per  cent  is  hardly  in  a  position  to  hold  the  cotton, 
and  the  sale  of  the  product  is  his  proper  course.^ 

Real  Estate  Mortgage  Security 

Urban  Real  Estate 

It  is  natural  to  think  that  losses  should  seldom  if 
ever  occur  in  connection  with  real  estate  loans.  When 
they  do  occur  the  lending  banker  is  himself  frequently 
puzzled  as  to  the  cause.  The  scene  for  losses  on  real 
estate  loans  is  usually  set  in  ''boom"  times,  when 
valuations  tend  to  be  too  high  and  surroundings  im- 
properly judged.  The  maker  of  a  real  estate  loan  will 
reduce  his  losses  by  taking  as  a  valuation,  neither  the 
price  which  the  owner  would  be  willing  to  pay  nor  the 
price  at  which  it  could  probably  be  sold  by  the  mort- 
gagee under  foreclosure  on  time,  but  the  price  at  which 
it  could  be  sold  by  the  mortgagee  under  foreclosure  for 

1  Cf.  A.  W.  Wilson,  The  Bank  and  the  Wheat  Crop,  Proceedings, 
Twenty-Ninth  Annual  Convention,  Kansas  Bankers'  Association, 
1916,  pp.  103,  104. 

2  Report  of  the  Committee  on  Negotiable  Cotton  Warehouse  Receipts, 
Proceedings,  Twenty-First  Annual  Convention,  Mississippi  Bank- 
ers' Association,  1909,  p.  70. 


232  BANK  CREDIT 

cash.  Allowance  should  be  made  for  interest  during 
the  time  required  for  the  process  of  foreclosure,  cost  of 
foreclosure,  and  depreciation,  which  may  be  serious 
during  the  time  of  foreclosure. 

Vacant  properties  held  for  speculative  purposes 
are  most  dangerous,  and  more  than  half  the  forced 
value  should  never  be  loaned  on  such  security.  Care 
should  not  be  spared  in  making  a  loan  on  a  costly 
property  in  a  poor  neighborhood;  a  moderately  good 
property  in  a  desirable  neighborhood  is  much  better 
security.^ 

Farm  Land  as  Security 

With  reference  to  farm  land  as  security,  many  factors 
have  to  be  considered.  A  tendency  or  disposition  of 
the  ''young  blood"  to  stay  on  the  farms,  a  degree  of 
thrift  in  the  community  sufficient  to  insure  ownership, 
clannishness  of  farmers  round  about  and  their  desire 
to  be  in  the  neighborhood  of  their  relatives,  absence 
of  large  speculative  holdings  near  by,  good  and  per- 
manent markets,  the  character  of  the  soil,  climate 
and  population  to  continue  successfully  along  the  lines 
of  the  existing  system  of  agiiculture  and  the  adaptabil- 
ity or  power  successfully  to  change,  should  change  in 
crops  or  methods  occur, — all  these  are  elements  in  the 
problem  of  determining  the  value  of  farm  land  as 
security  for  a  loan. 

One  of  these  elements  or  factors  requires  ampli- 
fication, \'iz.,  a  degree  of  thrift  sufficient  to  secure 

1 R.  W.  Smylie,  Doubtful  Debts;  Earnings  and  Competition, 
Proceedings,  Twelfth  Annual  Convention,  Michigan  Bankers' 
Association,  1900,  pp.  53,  54. 


SECURED  LOANS  233 

ownership,  and  its  corollary,  the  condition  of  indebted- 
ness of  the  community.  In  the  event  of  adversity, 
such  as  crop  failure,  a  conmiunity  lacking  in  thrift  and 
accumulated  wealth  in  forms  other  than  equitj''  in  land 
not  only  fails  to  pay  interest  but,  in  the  absence  of  ready 
cash  to  pay  the  defaults,  and  to  take  the  land  from  the 
delinquents,  witnesses  the  forcing  of  land  on  the  market 
when  there  are  few  or  no  purchasers.  A  marked  fall  in 
prices  results  inevitably.  Lands  subject  to  heavy  ditch 
or  other  taxes  may  be  difficult  and  burdensome  to  hold 
during  a  lean  period,  but  widespread  individual  in- 
cumbrance, uncommon  in  thrifty  communities,  is  an 
even  more  unfavorable  condition.^ 

The  immediate  neighborhood  of  a  piece  of  land  must 
also  be  carefully  considered.  As  is  true  of  urban  prop- 
erty, a  good  piece  of  farm  land  in  a  poor  locahty  is 
handicapped  by  its  surroundings.  On  the  other  hand, 
a  poor  piece  of  pasture  surrounded  by  good  farms  will 
not  likely  lack  a  purchaser,  and,  as  security,  is  more 
desirable  than  if  adjacent  to  land  of  the  same  character, 
for  reasons  that  are  plain. 

How  difficult  it  is  satisfactorily  to  appraise  land 
values  is  shown  by  one  or  two  instances  where  differ- 
ences in  evaluation  were  very  wide.  In  one  case  an 
appraiser  recommended,  reluctantly,  a  loan  of  $18,000 
on  a  certain  tract.  Soon  thereafter  the  owner  suc- 
ceeded in  borrowing  $40,000  on  the  security  of  the 
same  land.  In  another  instance,  which  occurred  ac- 
cidentally and  unknown  to  the  appraisers  concerned, 

1  E.  L.  Johnson,  The  Correct  Estimate  of  Land  Values  as  a  Basis  for 
Real  Estate  Loans,  Proceedings,  Eleventh  Annual  Meeting,  Iowa 
Bankers'  Association,  1897,  pp.  91,  92. 


234  BANK  CREDIT 

two  appraisers  employed  by  the  same  lending  com- 
pany, and  both  experienced  men,  appraised  the  same 
farm  and  were  so  far  apart  in  their  valuations  that  the 
difference  was  greater  than  either  the  margin  or  the 
equity  on  the  basis  of  what  the  owner  himself  would 
have  regarded  as  a  fair  loan.^  Appraisers  differ,  and 
farm  values  as  represented  by  appraisals  are  a  very 
uncertain  quantity. 

It  may  be  stated  as  a  general  principle  that  loans 
made  on  high-priced  land  are  safer  than  those  secured 
by  low-priced  tracts.  This  is  true  for  several  reasons. 
In  the  first  place,  a  very  appreciable  community  value 
exists  in  nearly  all  the  high-priced  land  regions,  and 
the  rate  of  'turnover"  on  high-priced  land  is  greater 
than  that  on  cheap  land.  Then,  cheap  land  deterior- 
ates more  rapidly  with  the  same  degree  of  misuse  than 
does  high-priced  land.  Hence  there  is  a  stronger 
tendency  to  abandon  the  cheaper  land.  Again,  land 
values  seem  to  fluctuate,  particularly  decline,  not  on  a 
percentage  basis  but  on  a  flat  dollar  per  acre  basis,  ^ 
placing  a  great  handicap  on  the  cheap  land.  There  is 
much  less  likelihood  of  land  now  worth  $100  per  acre 
falling  to  a  value  of  $50  per  acre  than  there  is  of  land 
worth  $25  per  acre  falling  to  $12.50, — which  is  another 
way  of  saying  that  the  percentage  margin  of  safety 
should  be  higher  in  the  case  of  low  grade  land  pledged 
as  security  than  in  the  case  of  high  grade  land  used  for 
the  same  purpose,  in  order  that  the  degree  of  safety  in 
the  two  instances  may  be  equal. 

1  D.  H.  Deane,  Factors  Affecting  Appraisals  in  Determining  Land 
Value,  Trust  Companies,  Vol.  XXV,  No.  5,  November,  1917,  p.  462. 

2  Idem,  op.  cit,  pp.  462,  463. 


CHAPTER  XIII 

OVERDKAFTS 

The  overdraft,  much  less  common  in  American 
banking  than  in  England  and  Scotland/  represents 
a  loan.  The  overdi'aft  is,  therefore,  one  form  of  bank 
credit. 

Now  an  overdraft  is  frequently  the  result  of  error. 
If,  however,  errors  are  large  and  frequent,  they  are 
probably  not  merely  inadvertent.  Overdrafts  are  also 
the  result  of  chronic  indifference  on  the  part  of  the 
depositor.  They  are  also  to  be  expected  in  connection 
with  the  accounts  of  depositors  that  are  hard  pressed 
for  capital.  Business  firms  newly  established,  whose 
trade  is  less  brisk  than  was  expected,  are  likely  to  over- 

1  The  system  of  cash  credits,  most  fully  developed  by  the  banks  of 
Scotland,  in  accordance  with  which  borrowers  are  enabled  to  secure 
the  privilege  of  drawing  on  the  bank  up  to  an  amount  arranged  for, 
paying  interest  on  only  what  is  actually  drawn  from  the  bank,  is 
often  referred  to  as  having  been  a  most  powerful  force  in  the  develop- 
ment of  the  resources  of  Scotland  and  the  advancement  of  its  agri- 
culture, commerce,  and  manufactures.  A  cash  credit  may  be  defined 
as  permission  to  run  an  overdraft  secured  by  good  bondsmen,  limited 
in  amount  and  to  be  reduced  to  small  proportions,  if  not  entirely 
repaid,  at  certain  times.  Permission  to  overdraw  may  stand  for  a 
long  period  of  years  unless  the  bank  becomes  dissatisfied  with  the 
bondsmen  or  they  withdraw  from  the  obligation.  Cj.  John  Johns- 
ton, Scottish  Banking  System,  Proceedings,  Twenty-Eighth  Annual 
Convention,  American  Bankers'  Association,  New  Orleans,  1902, 
p.  78. 

235 


236  BANK  CREDIT 

draw  their  accounts.  Farmers,  eager  to  ''get  out  of 
debt"  and  having  an  ahnost  insatiable  appetite  for 
more  land,  as  a  rule  maintain  either  no  bank  accounts 
or  only  small  balances.  The  farmer  may  leave  a  stand- 
ing order  at  the  bank  to  call  him  up  if  he  overdraws.^ 
Banks,  as  well  as  business  concerns,  overdraw  their 
accounts  occasionally.  IMany  country  banks  in  the 
South  have  had  annoyances  arising  out  of  delay  in  the 
mails  or  telegraph  delivery  remittances.  Frequently, 
when  such  delays  have  occurred  Northern  banks  have 
protested  the  checks  without  notice  to  the  banks  that 
drew  them,  to  the  deterioration  of  the  credit  of  the 
drawing  bank.^  In  general,  however,  bankers  in  the 
past,  particularly  before  1915  when  the  Comptroller  of 
the  Currency  issued  a  ruling  to  national  banks  against 
the  practice,  have  taken  the  position  that  there  is  no 
use  of  making  an  enemy  for  the  bank  because  of  an 
overdraft  of  one  hundred  dollars  or  less,  which  might 
influence  unfavorably  that  many  depositors. 

Where  overdrafts  are  very  large  the  condition  can 
sometimes  be  explained  by  reference  to  competition, 
and  particularly  among  banks  that  are  not  subject  to 
strict  super\'ision.  A  big  hearted  private  banker  is 
more  likely  to  be  imposed  upon  by  his  depositors  than 
the  national  banker  of  similar  temperamental  make- 
up.   But  a  national  bank  may  be  in  keen  competition 

^  W.  H.  Smith,  Balances  as  a  Basis  of  Credit,  Proceedings,  Fif- 
teenth Annual  Convention,  South  Carolina  Bankers'  Association, 
1915,  p.  10. 

2  T.  J.  Byerly,  Troubles  of  a  Banker  Arising  from  the  Overdraft, 
Proceedings,  Thirteenth  Annual  Convention,  North  Carolina  Bank- 
ers' Association,  1909,  p.  148. 


OVERDRAFTS  237 

with  a  private  or  state  bank  operated  under  less  strict 
examination  and  supervision  and  find  it  difficult  to 
keep  its  ledger  free  from  overdrafts  on  account  of  that 
competition.  Such  a  national  bank  in  Ohio  (Mt. 
Sterling)  at  one  time  had  total  resources  of  approx- 
imately $400,000  and  overdrafts  of  about  $50,000.  At 
that  time  it  was  not  uncommon  for  the  two  banks  in 
Mt.  Sterling,  a  town  of  1,200  inhabitants,  to  have 
overdrafts  in  excess  of  the  total  overdrafts  of  all  the 
banks  in  any  city  in  the  state.  ^ 

Objectionable  Features 

The  overdraft  is  highly  objectionable  on  several 
grounds.  It  is  the  result  of  somebody's  miscalcula- 
tion or  carelessness  and  without  definite  agreement 
as  to  its  terms.-  Overdrafts  are  unavailable  in  case 
of  need.  They  cannot  be  rediscounted.  Furthermore 
it  is  maintained  that  in  the  liquidation  of  the  affairs  of 
defunct  banks  the  percentage  of  loss  from  overdrafts  is 
much  larger  than  where  the  loan  is  secured  by  note.^ 
In  many  instances  large  loans  that  have  endangered 
the  safety  of  banks  began  as  overdrafts.  In  these  cases 
the  banks  tried  to  protect  themselves  by  converting  the 
overdraft  into  a  loan  when  it  was  so  late  that  the  note 

1  R.  H.  Schryver,  How  the  Rural  Banks  May  he  Benefited  by  the 
Federal  Reserve  Bank,  Proceedings,  Twenty-Fifth  Annual  Conven- 
tion, Ohio  Bankers'  Association,  1915,  p.  68. 

2  Thornton  Cooke,  The  Passing  of  the  Overdraft,  Proceedings, 
Twenty-Eighth  Annual  Convention,  Kansas  Bankers'  Association, 
1915,  p.  85. 

» J.  H.  Cranford,  Trials  of  a  Country  Banker,  Proceedings,  Ala- 
bama Bankers'  Association,  1904,  p.  51. 


238 


BANK  CREDIT 


at  best  represented  only  a  hope.^  It  is  probably  true 
that  a  banker  able  to  say  no  when  he  feels  a  loan  is  un- 
safe often  permits  an  overdraft  rather  than  protest  a 
check. 

In  State  and  National  Banks 

State  banks,  as  well  as  national,  have  been  gross 
offenders  in  respect  to  overdrafts.     The  state  institu- 


PeaCeNT 
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7870     JB7S     leBo     rs&s     /S30     yeas      raoo     790s     73to      79t.s      rsso 

Diagram  7 

tions  have,  however,  in  some  instances,  offered  the 
excuse  to  examiners  that  they  allowed  overdrafts  be- 
cause competing  national  banks  allowed  them.^ 

How  extensive  a  place  the  overdraft  has  occupied 
in  the  assets  of  our  national  banks  is  shown  by  dia- 
gram 7, — based  on  reports  of  the  Comptroller  of  the 

^  R.  N.  Sims,  Banks  and  Their  Obligations,  Proceedings,  Louisiaup 
Bankers'  Association,  1917,  p.  49. 
=  Idem,  op  cit.,  p.  48. 


OVERDRAFTS  239 

Currency, — in  which  is  shown  the  ratio  of  overdrafts  to 
loans.  It  is  clear  from  the  diagram  that  the  trouble- 
some item  is  passing.  State  banks  and  trust  companies 
have  shown  the  same  tendency,  only  less  strong,  to 
reduce  this  red  ink  item.  From  1910  to  1916  the  ratio 
of  overdrafts  to  loans  in  all  non-national  banks  fell 
from  .52  to  .31  per  cent. 

Rules  for  Controlling  Overdrafts 

Where  overdrafts  are  allowed  at  all,  the  banker 
may  be  governed  advantageously  by  the  following 
considerations : 

1.  Let  it  be  fully  understood  that  an  overdraft  is  an 
exceptional  privilege,  granted  only  for  the  time  being 
and  in  emergency. 

2.  When  overdrafts  occur,  as  by  mistake,  notify  the 
customer  at  once,  requesting  him  to  settle. 

3.  Grant  the  privilege  to  no  one  about  whose  ability 
or  wilhngness  to  pay  there  is  any  doubt. 

4.  Charge  interest  as  on  any  other  advance  of  funds. 

5.  Suggest  in  a  friendly  manner  to  the  customer  who 
asks  to  be  allowed  to  overdraw  that  it  is  contrary  to  the 
poHcy  of  the  bank  and  that  an  advance  on  note  would 
be  a  favor  to  the  banker.^ 

6.  Rather  than  permit  an  overdraft,  particularly 
in  connection  with  the  operation  of  buying  grain  and 
stock,  hold  a  demand  note  for  a  sufficient  sum  to  pre- 
vent it,  even  if  interest  is  charged  only  on  the  sum  used. 

*  W.  G.  Dillon,  Overdrafts,  Excessive  Loans,  Past-Due  Paper, 
Proceedings,  Seventeentii  Annual  Convention,  Tennessee  Bankers' 
Association,  1907,  p.  72. 


240  BANK  CREDIT 

7.  Educate  the  merchant  and  others  to  purchase 
drafts,  rather  than  send  personal  checks. 

8.  There  is  a  tj^^e  of  depositor  that  insists  on  making 
use  of  the  overdraft  in  order  to  avoid  paying  interest 
on  funds  he  might  not  use.  He  may  be  going  out  of 
town  and  is  not  sure  he  will  need  additional  funds.  The 
banker  ought  to  interrogate  such  customers  politely 
and  closely  as  to  who  is  under  greater  obligation  to 
hold  funds  in  readiness  to  meet  the  emergencies  of  the 
customer's  business,  the  banker  or  the  customer  him- 
self. ^ 

9.  A  customer,  let  the  banker  bear  in  mind,  is  natur- 
ally afraid  to  attempt  to  overdraw  the  first  time,  but 
after  doing  it  successfully  once  the  precedent  is  es- 
tablished. A  customer  is  not  likely  to  take  offense  if 
his  first  attempt  to  overdraw  is  frustrated.  It  is 
challenging  the  second  or  third  offense  that  creates 
enmity. 

Depend  upon  Bank  Supervision 

Whether  in  the  case  of  a  customer  attempting  to 
overdraw  for  the  first  tii?ie  or  in  the  case  of  one  hard- 
ened to  the  practice,  it  is  a  very  present  help  to  the 
banker  to  have  his  hands  upheld  by  bank  supervising 
authorities.  Overdrafts  are,  in  fact,  a  function  of  the 
thoroughness  of  bank  supervision.  Strict  supervision 
mihtates  against  robust  advances  in  this  form.  By 
way  of  illustration  it  may  be  mentioned  that  over- 
drafts in  the  state  banks  of  Nevada  were  reduced  from 
$485,000  in  January,  1911,  when  a  new  law  providing 
for  effective  supervision  went  into  effect,  to  $46,012, 

1  J.  H.  Cranford,  op.  cit.,  p.  52. 


OVERDRAFTS  241 

less  than  two  and  a  half  years  later.  ^  Bankers  them- 
selves, supervision  apart,  are  able  to  keep  this  fractious 
item  within  narrow  bounds  only  through  the  execution 
of  a  firm  and  tactful  policy. 

An  Index  of  the  Soundness  of  the  Bank 

Overdrafts  are,  it  follows,  an  index  of  the  character 
of  the  bank.  A  large  overdraft  item  on  the  financial 
statement  is  an  almost  certain  indication  that  the 
"note  pouch  is  bulging  with  rotten,  mouldy  notes  that 
long  since  should  have  been  charged  off."  ^  Large 
overdrafts  signify  an  easy-going  management  and  an 
inferior  clientele. 

1  Eugene  Howell,  State  Banks  of  Nevada,  Proceedings,  Fifth 
Annual  Convention,  Nevada  Bankers'  Association,  1913,  p.  52. 

2  A.  L.  Mills,  Doubtful  Banking,  Proceedings,  Oregon  State  Bank- 
ers' Association,  1907,  pp.  43,  44. 


CHAPTER  XIV 

Loans  of  Country  Banks 

Distinctive  Features  of  Country  Bank  Loans 

There  are  several  features  of  loans  made  by  country 
banks  ^  that  contrast  sharply  with  credit  extended  by 
the  banking  institutions  of  the  cities.  In  the  first  place 
the  basis  of  the  country  bank  loan  is  highly  personal. 
The  country  banker,  through  acquaintance  and  con- 
tact with  customers  over  a  period  of  years,  possesses  a 
close  personal  knowledge  of  his  borrowers.  He  is, 
therefore,  justified  frequently  in  giving  more  consider- 
ation to  character  and  capacity  than  would  the  city 
banker.  The  country  banker  feels  warranted  at  times 
in  extending  credit  to  men  whose  assets  are  negligible, 
and  in  few  cases  can  he  rigidly  observe  the  proportion  of 
2  to  1  of  quick  assets  to  current  liabilities.  While  the 
city  institution  may  regard  loans  beyond  one  third  of 
the  borrower's  net  worth  as  excessive,  the  country 
banker  finds  it  safe  in  many  cases  to  lend  up  to  seventy 
five  per  cent  of  a  borrower's  net  worth,  when  the  bor- 
rower is  a  man  of  known  probity  and  capacity,  who  is 
certain  to  devote  his  last  dollar  to  paying  his  debts. 

1  The  term  country  banks  is  used  in  this  chapter,  not  as  it  is  em- 
ployed in  the  National  Bank  Act,  but  to  designate  banks  operating 
outside  the  major  cities.  Any  bank  the  loans  of  which  are  made  in 
considerable  part  to  rural  interests  would  fall  ia  the  class  of  country 
banks  as  the  term  is  here  used. 

242 


LOANS  OF  COUNTRY  BANKS  243 

What  the  country  bank  lacks  in  credit  files  and  in 
"credit  men"  is  offset  in  part  by  the  fact  that  directors 
as  well  as  the  lending  officers  of  such  banks  have  this 
close  acquaintance  with  the  affairs  of  borrowers.  The 
directorates  of  country  banks  are  so  constituted  as 
frequently  to  make  the  combined  possible  contribu- 
tion of  credit  information  of  the  members  reasonably 
accurate  and  reasonably  complete.  Instance  the  per- 
sonnel of  the  board  of  a  successful  western  bank.  The 
president  of  the  bank  was  previously  to  his  taking  up 
the  banking  business  the  manager  of  a  lumber  yard  and 
"sold  through  the  valley,"  one  of  the  directors  was  the 
village  doctor,  whose  practice  extended  for  twenty 
miles  around;  another,  the  blacksmith,  and  still 
another  the  proprietor  of  a  livery  stable.  When  that 
board  finished  talking  a  borrower  over  they  knew  about 
all  there  was  to  know  about  his  credit.^ 

A  second  distinguishing  feature  of  country  bank 
loans  is  that,  unfortunately  for  the  country  banker, 
notes  cannot  always  be  selected  from  the  most  attrac- 
tive class  of  customers.  The  customers  whose  notes 
the  banker  would  like  most  to  have  in  his  note  case  are 
frequently  not  borrowers.  The  actual  borrowers  are 
those  who  through  the  use  of  borrowed  funds  will  in 
time  place  themselves  in  that  exclusive  class.  The 
country  bank  borrower  whose  paper  is  not  gilt  edged 
may  be  expected  in  the  majority  of  instances  to  im- 
prove the  quaUty  of  his  paper  through  the  use  of  funds 
borrowed  and,   in   the  fulness  of   years,   enjoy   that 

1  Jas.  K.  Lynch,  Banking  in  Theory  and  Practice,  Proceedings, 
Seventh  Annual  Session,  Arizona  Bankers'  Association,  1910, 
p.  38. 


244  BANK  CREDIT 

happy  credit  state  where  borrowing  is  no  longer 
necessary.^ 

In  the  next  place,  the  extension  of  credit  by  city 
banks  is  frequently  based  in  part  on  the  average 
monthly  balance  maintained.  In  country  banks  this  is 
scarcely  a  governing  factor  inasmuch  as  it  often  hap- 
pens that  the  most  solvent  borrowers  maintain  the 
smallest  balances.  The  money,  which  is  needed  for  a 
specific  purpose  and  immediate  use,  is  soon  checked  out. 
The  size  of  the  balance  maintained  at  other  than 
borrowing  seasons,  however,  does  and  should  influence 
the  lending  officer  in  determining  the  amount  of  credit 
to  be  extended."  Many  farmers  do  not  appreciate  the 
convenience  of  keeping  a  bank  account,  nor  the  advan- 
tage and  importance  of  cultivating  cordial  and  confi- 
dential relations  with  a  banker. 

Again,  country  bankers  do  not  generally  find  de- 
mand loans  against  collateral  highly  desirable.  The 
highest  type  of  collateral  is  seldom  afforded  the  country- 
banks;  what  they  usually  get  is  second  or  third  rate 
securities,  salable  on  a  rising  market,  slow  of  sale  in 
periods  of  dullness  and  quite  immovable  in  times  of 
panic.  Then  there  is  no  automatic  Hquidation  of  such 
loans.  The  borrower  usually  holds  for  a  rise  and  if  the 
market  is  not  favorable  he  may  desire  to  have  the  loan 
carried  indefinitely.^ 

1 W.  S.  Weston,  The  Credit  Department  of  a  Country  Bank,  Pro- 
ceedings, Sixteenth  Annual  Convention,  Nebraska  Bankers'  Asso- 
ciation, 1912,  pp.  36,  37. 

2  W.  C.  Gordon,  Proceedings,  Forty-Second  Annual  Convention, 
American  Bankers'  Association,  1916,  p.  526. 

» C/.  Jas.  K.  Lynch,  Banking  in  Theory  and  Practice,  Proceedings, 


LOANS  OF  COUNTRY  BANKS  245 

The  loans  of  the  country  bank  are  also  ''slow"  in 
comparison  with  loans  made  by  city  institutions. 
Loans  of  country  banks  to  their  merchant  borrowers 
are  likely  to  be  characterized  by  renewals  due  to  the 
habitual  slowness  of  merchants  in  making  collections. 
The  country  merchant  is  generally  many  months, 
sometimes  more  than  a  year,  in  making  his  collections.^ 
Loans  to  merchants  in  the  cities  where  sales  are  for 
cash,  or  for  not  more  than  30  days'  credit,  contrast 
sharply  with  those  to  country  store-keepers  whose 
customers  are  farmers  with  long  periods  between  har- 
vests. Loans  to  farmers  in  new  sections  of  the  country 
are  very  slow.  One  case  is  on  record  where  the  in- 
terest was  paid  for  fourteen  years  before  repayment  of 
the  principal. 2  These  long-time,  often-renewed  loans 
are  appropriately  called  ''sleepers." 

In  a  country  where  commercial  and  banking  obliga- 
tions are  met  with  a  reasonable  degree  of  promptness 
bank  loans  are  likely  to  be  at  a  minimum  at  the  turn 
of  the  year.  The  writer  has  found  one  instance  of  a 
bank,  in  the  South,  whose  statement  of  condition  as  of 
December  31  showed  no  loans,  all  of  its  funds  being  in 
cash  and  on  deposit  with  correspondents.  Cotton  had 
been  marketed  early  and  the  growers  had  promptly 
paid  their  store  bills,  enabling  the  merchants  to  liquid- 
Seventh  Annual  Session,  Arizona  Bankers'  Association,  1910, 
p.  34. 

1  Justice  C.  C.  Craig,  Local  Bills  Receivable,  Proceedings,  Thirty- 
Sixth  Annual  Convention,  Illinois  Bankers'  Association,  1916, 
p.  127. 

*  E.  N.  Morrill,  Reminiscences  of  Banking  in  Kansas,  Proceedings, 
Eighteenth  Annual  Convention,  Kansas  Bankers'  Association,  1905, 
p.  55. 


246  BANK  CREDIT 

ate  their  loans  at  the  bank.^  This  condition  of  having 
all  loans  retired  is  cited  because  of  its  exceptional 
nature. 

A  country  banker  addressing  the  Missouri  Bankers' 
Association  in  1911,  stated  that  during  a  single  month, 
not  especially  chosen,  for  which  computation  had  been 
made,  65  per  cent  of  all  maturing  paper  was  renewed 
and  35  per  cent  paid.  He  believed  that  in  many 
strictly  agricultural  districts  the  percentage  of  liquida- 
tion was  even  less.  Every  tendency  seems  to  work 
against  liquidation,  and  the  measure  of  hquidation  is 
very  much  lessened  in  time  of  stringency. - 

When  a  renewal  of  a  note  is  sought,  that  action 
in  itself  may  be  evidence  that  the  purpose  of  the  loan 
has  miscarried,  or  that  the  proceeds  are  being  diverted 
to  uses  other  than  those  for  which  the  loan  was  granted. 
If  failure  to  repay  promptly  has  been  due  to  a  bad 
business  season  or  to  the  personal  misfortune  of  the 
borrower,  his  efforts  should  be  redoubled  in  order  that 
the  obligation  may  certainly  be  met  at  its  next  matur- 
ity. Repeated  requests  for  renewal  generally  signify 
carelessness  or  financial  weakness,  or  both,  and  the 
prudent  banker  ought  to  take  prompt  steps  to  protect 
his  interests.^ 

Single  name  paper  gives  very  little  trouble  to  the 
banker  in  not  being  paid  promptly  or  in  being  renewed. 
One  name  paper  is  likely  to  be  settled  for  or  renewed 
when  due  simply    because  its  maker  is  able  to  borrow 

^Bulletin,  American  Institute  of  Bank  Clerks,  Vol.  VI,  p.  243. 

^E.  R.  Gumey,  A  Study  in  Liquidation,  Proceedings,  Twenty- 
First  Annual  Convention,  Missouri  Bankers'  Association,  1911, 
p.  73.  » W.  C.  Gordon,  op.  cit.,  p.  526. 


LOANS  OF  COUNTRY  BANKS  247 

from  the  bank  without  getting  security  and  feeling 
complimented  and  not  under  the  necessity  of  getting 
other  names  on  his  renewals  he  finds  that  renewal 
easy.^  Single  name  borrowers  are  prompt  in  meeting 
their  bank  obhgations  and  bankers  have  learned  to 
avoid  taking  endorsed  notes  when  there  is  a  possi- 
bihty  that  the  endorser  may  be  called  upon  to  pay  the 
debt.  It  is  a  very  difficult  matter  to  collect  notes  from 
endorsers,  representing  debts  which  are  not  their  own. 
Many  men  will  pay  their  own  obligations  unfailingly 
and  cheerfully,  who  will  pay  only  with  great  reluctance 
notes  endorsed  for  others.-  It  generates  an  unfriendly 
feeling  toward  the  bank  when  an  accommodation  en- 
dorser is  forced  to  pay. 

Notes  with  two  or  more  names  are  very  likely  to 
furnish  past-due  paper.  The  reasons  are,  first,  that  a 
note  which  has  to  have  more  than  one  name  on  it  to  be 
satisfactory  is  itself  evidence  that  the  maker  is  not  as 
successful  and  prompt  as  if  his  own  name  alone  had 
been  accepted,  and,  second,  that  the  principal  on  the 
note  in  order  to  avoid  the  unpleasantness  of  going 
around  to  his  endorsers  to  get  them  to  renew  with  him 
will  frequently  try  to  induce  the  banker  to  defer  pay- 
ment on  over-due  paper  so  as  to  admit  of  its  being  paid 
off  in  installments.^ 

1  John  A.  Crabb,  Overdrafts  and  Past-Due  Paper,  Proceedings, 
Seventeenth  Annual  Convention,  Kentucky  Bankers'  Association, 
1909,  p.  121. 

2  C.  C.  K.  Scoville,  The  Best  Class  of  Investments  for  the  Average 
Kansas  Bank,  Proceedings,  Sixteenth  Annual  Convention,  Kansas 
Bankers'  Association,  1903,  p.  76. 

» John  A.  Crabb,  op.  oil.,  p.  122. 


248  BANK  CREDIT 

The  borrowers  of  country  banks  frequently  keep 
no  record  of  and  do  not  know  the  amount  of  their 
notes  held  by  their  bank  and  consequently  inquire 
of  the  banker  habitually  as  to  the  number,  amounts, 
maturities,  and  perhaps  the  security  of  their  obUga- 
tions.  If  the  banker  has  to  look  through  the  pockets 
of  his  portfolio  valuable  time  is  required,  and  the 
omission  of  one  or  more  notes  might  cause  serious 
trouble  later.  A  note  ledger  indexed  serves  as  a  satis- 
factory^ means  of  ascertaining  the  information  quickly, 
impressing  the  customer  with  the  idea  that  the  banker 
has  the  details  of  his  business  well  in  hand.  A  column 
opposite  the  dates  of  maturity  should  contain  the  dates 
of  pajTnent,  enabhng  the  banker  to  tell  at  a  glance 
whether  the  borrower  is  a  prompt  payer.  Borrowers' 
knowledge  of  the  existence  of  a  note  ledger  and  of  its 
nature  is  a  spur  to  prompt  payment.  Young  men 
applying  for  their  first  loan  may  be  started  right 
by  simply  being  shown  the  record  kept  by  the 
bank. 

The  e\dls  of  slow  and  past  due  paper  have  attracted 
no  small  amount  of  attention  among  country  bankers 
and  with  improving  financial  conditions  among  farm- 
ers country  bank  loans  are  becoming  more  and  more 
hquid. 

Rules  for  Reducing  Slow  and  Past  Due  Paper 

The  banker  w^ho  desires  to  accelerate  the  reduction 
of  his  slow  and  past  due  paper  may  well  proceed  along 
the  following  Unes : 

1.  Let  the  seeker  of  credit  know  in  conversation  not 
directed  pointedly  at  him  how  much  you  appreciate  a 


LOANS  OF  COUNTRY  BANKS       249 

good  prompt  customer,  how  you  make  a  special  effort 
to  help  that  class  of  borrowers  in  a  stringency.^ 

2.  Accept  no  notes  that  do  not  provide  for  waiving 
protest,  notice  of  protest,  and  for  cost  of  collection. 

3.  Send  notices  to  borrowers  from  five  to  ten  days 
before  date  of  maturity. 

4.  Collect  past  due  interest. 

5.  After  a  reasonable  time  beyond  day  of  maturity 
write  the  sureties,  stating  a  definite  day  on  which  en- 
forced collection  of  the  note  will  be  carried  out,  if  no 
adjustment  is  made  in  the  meantime.^ 

Loans  to  Tenants 

The  average  tenant  deserves  the  careful  considera- 
tion of  the  lending  banker.  Tenants  of  the  better  class 
in  the  Middle  West  who  occupy  large  and  well  im- 
proved farms  are  frequently  worth  from  $4,000  to  $10,- 
000  or  more  in  farm  implements,  horses  and  other  live 
stock.  If  a  tenant  has  lived  long  in  the  community,  the 
banker  will  have  no  trouble  in  finding  out  whether  he 
is  honest  and  what  chance  he  has  of  succeeding  on  the 
farm  that  he  has  rented.  If  the  tenant  is  honest  and 
industrious,  has  good  equipment,  and  has  a  lease  that 
is  fair,  the  banker  will  generally  be  justified  in  extending 
credit.^  In  cases  where  the  outcome  of  a  loan  is  in  doubt 
a  chattel  mortgage  may  at  times  be  executed,  although 
the  chattel  mortgage  is  not  in  high  esteem  among 

*  John  A.  Crabb,  op.  cit.,  pp.  125,  126. 

^W.  G.  Dillon,  Overdrafts,  Excessive  Loans,  Past-Due  Paper, 
Proceedings,  Seventeenth  Annual  Convention,  Tennessee  Bankers' 
Association,  1907,  p.  68. 

» Justice  G.  C.  Craig,  op.  dt.,  p.  127. 


250  BANK  CREDIT 

bankers,  except  in  the  rural  South  and  in  connection 
with  financing  the  operations  of  cattle  feeders  in  the 
central  and  southwestern  states. 

The  variety  of  notes  that  the  country  banker  has 
learned  by  experience  to  prefer  is  given  in  jaunty 
fashion  by  Mr.  E.  R.  Gurney.^ 

We  like  notes  taken  at  farm  auction  sales.  We  like  to  buy 
the  trade  paper,  Uttle  notes  from  and  endorsed  by  the  grocer, 
the  baker  and  candlestick  maker.  I  leave  out  of  the  trio  the 
butcher  because  paying  his  notes  is  too  much  like  pacing  for 
dead  horses.  We  like  all  little  notes  except  those  of  the 
lightning  rod  decorator  and  of  the  insurance  persuader. 
We  like  the  note  of  a  merchant  who  discounts  his  bills  and 
who  pays  us  as  religiously  as  he  does  other  people.  We  like 
farmers'  notes  given  for  feeding  cattle,  with  or  without 
mortgages.  We  like  the  note  of  him  who  has  wheat  in  the 
bin.  We  like  the  note  of  John  William  Jones  who  is  so  stingy 
that  he  uses  six  penny  nails  for  cuff  buttons  and  wakes  the 
roosters  out  of  sound  sleep  as  he  hammers  around  doing 
chores.  We  like  the  notes  of  old  maids  who  sew  for  a  dollar  a 
day  and  we  steer  clear  of  brilliant  young  men  who  have  a 
hundred  a  month  outgo  on  a  twelve  dollar  a  week  income. 

Whatever  the  variety  of  note  contained  in  the  country 
banker's  loans  and  discounts,  the  rate  of  interest  has 
generally  been  relatively  high. 

The  Rate  of  Interest 

The  rate  on  loans  made  by  country  banks  has  been 
notoriously  high  in  many  sections  of  the  West  and 
South. 2     ''One  per  cent  a  month  and  sometimes  a 

1  Op.  cit.,  pp.  76,  77. 

2  For  a  detailed  account  of  an  investigation  made  by  the  Comp- 
troller of  the  Currency  of  usurious  rates  charged  by  national  banks 


LOANS  OF  COUNTRY  BANKS  251 

little  rake-off  above  that"  has  been  not  an  uncommon 
charge  that  the  borrower  has  borne.  In  justification 
of  such  high  rates  the  banker  concerned  contends, 
first,  that  he  has  to  charge  a  great  deal  more  than  city 
banks  because  he  renders  more  expensive  service.  The 
city  banks  are  wholesalers  of  credit  and  lend  as  much  to 
one  customer  in  a  day  as  some  of  their  country  corre- 
spondents would  lend  in  a  season.  Relatively  high  costs 
of  doing  business  ought  to  be  reflected  in  relatively  high 
rates.  ^  A  second  circumstance  invoked  in  order  to 
justify  high  rates  is  that  a  majority  of  a  country  bank- 
er's customers  may  be  men  whose  credit  at  the  bank  is 
solely  a  matter  of  their  being  known  to  the  banker. 
''Now  most  of  my  customers,"  says  a  Georgia  banker, 
"are  men  that  I  deal  with  solely  on  the  basis  that  I 
know  the  men.  There  is  many  a  man  that  I  credit 
$100  or  $200  a  year,  that  not  another  bank  in  town 
would  think  of  crediting.  He  will  pay  me  and  the  other 
fellow  will  pay  the  other  man."^  The  customer's 
credit  in  many  cases  has  a  very  limited  currency,  hence 
the  high  rate. 

The  farmer  has  probably  paid  no  more  in  the  way  of 
interest  than  the  neighboring  business  man.  A  rural 
merchant's  paper  runs  from  90  days  to  six  months  and 
bears  8  per  cent  in  the  Gulf  States.  A  certain  propor- 
tion of  his  loan  he  keeps  on  deposit  to  be  drawn  out 

see  The  Commercial  and  Financial  Chronicle,  Vol.  101,  No.  2624, 
October  9,  1915,  pp.  1137,  1138. 

*  C.  T.  Smith,  Proceedings,  Twenty-Sixth  Annual  Convention, 
Georgia  Bankers'  Association,  1917,  p.  119. 

"^  R.  H.  Drake,  Proceedings,  Twenty-Sixth  Annual  Convention, 
Georgia  Bankers'  Association,  1917,  pp.  129,  130. 


252  BANK  CREDIT 

gradually  by  means  of  checks.  On  these  checks  the 
banker  may  earn  additional  profit  in  the  form  of  ex- 
change. The  farmers  may  pay  two  per  cent  more 
than  the  merchants,  but  their  paper  runs  for  six  to 
twelve  months.  Very  few  farmers  keep  any  balance, 
nor  is  much  exchange  earned  on  the  account.^  What  is 
true  in  the  Gulf  States  and  the  South  is  measurably 
true  in  other  sections. 

^  Proceedings,  Seventeenth  Annual  Convention,  North  CaroUna 
Bankers'  Association,  1913,  p.  39. 


CHAPTER  XV 
Loans  of  Banks  to  Banks 

There  are  several  ways  in  which  one  bank  may  lend 
to  another.  The  most  cormnon  is,  and  has  long  been, 
on  the  note  of  the  borrowing  bank  secured  by  accom- 
panjdng  collateral  in  the  form  of  stocks  or  bonds  or 
customers'  notes.  A  second  method  is  to  lend  on  the 
unsecured  note  of  the  borrowing  bank.  Rediscounting 
customers'  paper  is  a  third;  and  a  fourth  is  through  the 
purchase  of  bonds  or  other  securities  by  the  "lending" 
bank  with  the  understanding  that  the  same  securities 
are  to  be  sold  back  to  the  "borrowing"  institution  in 
due  time.  Banks  also  make  advances  to  other  banks 
in  exchange  for  certificates  of  deposit.  The  writer 
knows  of  one  bank  that  "lends"  to  other  banks  on 
certificate  of  deposit  in  order  to  secure  convenient 
means  of  concealing  profits  and  assets.  Of  these  meth- 
ods of  lending,  as  employed  outside  the  Federal  Reserve 
banks,  the  lending  operations  of  which  were  fully  dis- 
cussed in  chapter  VI,  the  first  is  the  usual  and  pre- 
vailing one. 

The  following  table  contains  the  amount  of  loans 
to  banks  made  by  national  banks  in  all  Reserve  and 
other  cities  having  a  population  of  over  75,000,  De- 
cember 27,  1916.1 

*  Report  of  the  Comptroller  of  the  Currency,  1917,  Vol.  I, 
p.  204. 

253 


254 

Cities 

BANK 

No. 

of 
banks 

CREDIT 

Direct  and 

indirect 

loans  to 

banks 

Securities,  etc.,  pur- 
chased from  banks 
with  agreement  to 
resell 

New  England  States . , 

Eastern  States , 

Southern  States , 

Middle  States 

Western  States , 

...     59 
...  181 
. ..     81 
. ..  124 
. ..     38 

$    8,042,115 
62,309,711 

9,528,530 
65,125,350 
17,991,908 

2,349,054 

$    295,042 

894,550 

23,500 

4,445,322 

Pacific  States 

, ..     39 

73,465 

...  522 

Total 

$165,346,678 

$5,731,878 

It  will  be  readily  observed  that  "securities,  etc., 
purchased  from  banks  with  agreement  to  resell"  con- 
stitute only  three  per  cent  of  the  combined  loans  made 
in  accordance  with  the  other  two  methods.  When  a 
bank  buys  bonds,  stocks,  or  commercial  paper  at  a 
given  price,  for  repurchase  at  the  same  specified  price, 
the  selling  bank  pays  interest  on  that  price. 

Where  the  borrowing  bank  is  not  required  to  bolster 
up  its  paper  with  that  of  its  customers'  it  is,  as  a  rule, 
because  the  lending  bank  is  satisfied  that  the  con- 
dition of  the  borrowing  institution  is  above  suspicion 
and  the  character  of  the  management  above  re- 
proach. 

In  the  numerous  cases  where  banks  send  along  their 
customers'  notes  as  collateral  those  notes  bear  not  the 
signatures  of  big  and  well  known  borrowers,  but  the 
names  of  those  whose  credit  standing  is  known  only 
locally.  Nevertheless,  cautious  lending  banks  do  make 
some  effort  to  ascertain  the  standing  of  the  makers  and 
endorsers  of  paper  submitted  as  collateral  and  when 


LOANS  OF  BANKS  TO  BANKS       255 

it  is  found  to  be  unsatisfactory,  substitution  may  be 
asked  for.  The  amount  of  the  collateral,  whether  rated 
or  unrated  paper,  is  maintained,  when  maturities  oc- 
cur, through  substitution.  The  margin  of  the  collateral 
over  the  face  of  the  loan  may  run  all  the  way  from  ten 
to  one  hundred  per  cent. 

If  the  lending  banker,  in  New  York,  let  us  say, 
knows  the  Southern  banker  who  is  borrowing  against 
receivables,  unrated  paper  is  probably  to  be  regarded 
as  not  inferior  to  rated  paper.  The  makers  of  the 
unrated  receivables  the  Southern  banker  knows,  and 
the  Southern  banker  may  be  fully  as  jealous  of  his 
bank's  interest  as  is  the  New  York  correspondent  of  his 
own.  Resting  on  a  close  knowledge  of  the  character  of 
the  maker  of  the  paper  and  the  value  of  his  resources, 
which  may  be  only  a  few  acres  and  a  gray  mule,  the  judg- 
ment of  the  Southern  banker  is  probably  better  than 
that  based  on  an  investigation  of  a  commercial  agency.  ^ 

How  nearly  free  from  loss  are  these  loans  of  banks 
to  banks  on  the  security  of  unrated  paper  is  shown  by 
the  fact  that  one  of  the  leading  New  York  banks  that 
lends  very  extensively  to  Southern  bankers  on  this 
form  of  security  suffered  no  losses  whatever  in  1914. 
The  same  institution  has  lost  only  a  few  thousand 
dollars  over  a  long  period  of  years. 

Lending  institutions  usually  require  that  the  borrow- 
ing bank  maintain  an  average  deposit  of  twenty  per 
cent  of  the  credit  extended.  There  are  many  excep- 
tions, however,  to  this  rule. 

'  A.  J.  McGrath,  The  Northern  Banker  Passing  on  Paper  Offered 
by  the  Southern  Bunker,  Proceedings,  Fourteenth  Annual  Conven- 
tion, Georgia  Bankers'  Association,  1905,  p.  99. 


256  BANK  CREDIT 

Investigating  the  Borrowing  Bank 

City  banks  employ  a  gi-eat  variety  of  methods  in 
attempting  to  ascertain  the  standing  of  a  bank  that 
has  appHed  or  that  may  apply  for  a  loan.  Many  New 
York  institutions  having  bond  salesmen  and  solicitors 
of  new  business  at  work  in  the  territory  of  their  bank- 
borrowing  clienteles  utilize  those  agencies  in  securing 
information  from  officers  of  other  banks.  Closer  infor- 
mation can  be  got  through  interviews  than  is  possible 
by  correspondence. 

It  would  be  erroneous,  however,  to  suppose  that 
banks  do  not  inquire  concerning  their  borrowing  cor- 
respondents by  writing  both  to  bankers  who  are 
located  in  the  borrower's  own  and  neighboring  towns 
and  to  other  correspondents  of  the  borrowing  institu- 
tion. 

Information  is  given  almost  invariably  on  what  the 
bankers  call  non-liability  paper,  paper  containing  a 
statement  to  the  effect  that  the  bank  giving  the  infor- 
mation does  so  as  a  matter  of  opinion  for  which  no 
responsibility  is  to  attach  "to  this  bank."  The  follow- 
ing non-liability  statement,  which  appears  on  letters 
sent  out  by  a  prominent  Chicago  bank  in  response  to 
requests  for  credit  information  is  typical: 

All  persons  are  informed  that  any  Statement  on  the  part 
of  this  Bank  or  any  of  its  Officers  as  to  the  Responsibility  or 
Standing  of  any  Person,  Firm  or  Corporation,  or  as  to  the 
value  of  any  Property  or  Securities,  is  a  mere  Matter  of 
Opinion,  and  given  as  such;  and  solely  as  a  matter  of  Cour- 
tesy, and  for  which  no  Responsibility,  in  any  way,  is  to 
attach  to  this  Bank  or  any  of  its  Officers. 


LOANS  OF  BANKS  TO  BANKS       257 

Non-liability  paper  is  also  used  in  making  replies  to 
inquiries  concerning  non-bank  borrowers. 

The  practice  of  city  banks  sending  representatives, 
frequently  vice-presidents,  over  the  country  to  attend 
bankers'  conventions  has  two  purposes:  (a)  to  secure 
new  business  and  (b)  to  secure  credit  information  in  a 
personal  and  very  expeditious  way.  The  most  capable 
representatives  of  the  metropolitan  banks  in  attending 
a  convention,  endeavor  in  addition  to  the  direct  solici- 
tation of  new  business,  to  obtain  credit  information 
along  three  distinct  lines: 

1.  Effort  is  made  promptly  to  meet  the  representa- 
tives of  correspondent  banks  present,  to  discuss  freely 
mutual  inter-bank  relations  and  to  obtain  as  much 
information  as  possible  concerning  the  nature  of  the 
business  carried  on  by  the  interior  institutions,  and 
whether  other  connections  or  affiliations  are  main- 
tained. Meeting  the  countiy  banker  face  to  face 
enables  the  officer  or  other  representative  of  the  city 
bank  to  form  a  definite  opinion  as  to  the  moral  risk. 

2.  As  far  as  possible  an  effort  is  made  to  get  an  inter- 
change of  views  with  other  correspondents  of  the  in- 
terior banks,  as  well  as  an  expression  of  opinion  from 
representative  local  concerns  respecting  the  credit 
standing  of  bank  correspondents  in  the  section  visited. 

3.  Business  methods  prevailing  in  the  locality  of 
the  country  bank  are  made  the  object  of  inquiry,  as 
are  the  development  of  the  resources  of  that  section 
and  the  basis  of  local  loans,  whether  cereals,  cotton, 
live  stock  or  other  commodities. 

The  information  secured  by  the  visiting  represen- 
tative is  later  copied  in  the  credit  files  of  the  institution 


258  BANK  CREDIT 

to  which  it  pertains  and  serves  as  an  important  help  in 
passing  inteUigently  and  fairly  upon  applications  for 
credit  coming  from  the  interior  bank.^ 

The  way  in  which  a  bank  handles  its  accounts  with 
the  city  correspondent  is  also  an  indication  of  char- 
acter. Balances  and  loans  over  long  periods  are 
watched;  overdrafts,  if  any,  are  noted.  Any  evidence 
of  business-like  methods  coming  to  the  attention  of 
the  lending  bank  does  not  fail  to  make  an  impression 
favorable  to  the  borrowing  institution.  Even  such  an 
apparently  trivial  matter  as  the  promptness  with  which 
reconciliation  slips  are  handled  is  closely  watched  as  an 
indication  of  carefulness  and  promptness  or  of  lax  and 
slip-shod  methods. 

Lending  institutions  welcome  a  suggestion  from  the 
borrowing  institutions  that  a  representative  be  sent  to 
make  an  examination  of  its  affairs  before  business  re- 
lations are  entered  into.  The  findings  of  such  a  special 
representative  are  almost  certain  to  be  diverse.  In  one 
case  the  conditions  and  methods  found  might  prove  a 
model  for  many  a  large  institution;  in  another  the  re- 
verse.^ 

A  Particular  Case 

I^et  us  now  examine  briefly  the  factors  underlying 
the  making  of  a  loan  by  a  bank  to  a  bank.  The  First 
National  Bank  of  Weston,  Ohio,  makes  an  application 
for  a  loan  of  $25,000.  In  anticipation  of  the  aforemen- 
tioned application  the  New  York  correspondent  has 

1  Proceedings,  Georgia  Bankers'  Association,  1905,  pp.  84-86. 

^  Cf.  A.  J.  McGrath,  The  Northern  Banker  Passing  on  Paper 
Offered  by  the  Southern  Banker,  Proceedings,  Fourteenth  Annual 
Convention,  Tha  Georgia  Bankers'  Association,  1905,  p.  100. 


LOANS  OF  BANKS  TO  BANKS       259 

found  out  about  the  standing  of  the  Weston  bank  by 
writing  to  banking  friends  in  Toledo,  Lima  and  perhaps 
elsewhere.  The  lending  officer  of  the  New  York  bank 
also  has  at  his  fingers'  ends  figures  showing  how  profit- 
able the  account  has  been,  and  facts  as  to  the  prompt- 
ness with  which  reconcilements  have  been  made,  etc. 
A  statement  of  the  Weston  bank  will  also  have  been 
secured  by  the  metropolitan  institution.  The  state- 
ment follows:^ 

Assets  Liabilities 

Loans  and  Discounts  .  .$142,704  Capital $  25,000 

U.  S.  Bonds 20,000  Surplus 10,000 

Banking  house,  Furni-  Undivided  Profits 757 

ture  and  Fixtures ..  .  10,000  Notes 20,000 

Other  Assets 7,159  Demand  Deposits 28,330 

Due  from  Banks 16,094  Time  Deposits 108,966 

Cash 8,909  Due  to  Banks 11,813 


$204,866  $204,866 

The  ratio  of  reserves  to  deposits  is  satisfactory,  as  is 
the  ratio  of  capital,  suplus  and  undivided  profits  to 
deposits.  The  bank  could  lose  almost  twenty  five  per 
cent  of  the  amount  of  its  loans  and  still  be  able  to  pay 
depositors  one  hundred  cents  on  the  dollar.  The  state- 
ment is  excellent;  the  standing  of  the  personnel  of  the 
bank  officers  and  directors  is  high;  the  bank  is  popular 
in  the  community,  assuring  the  improbability  of  heavy 
deposit  withdrawals;  business  and  crop  conditions  in 
and  round  about  Weston  are  promising;  the  extension 
of  the  loan  is  justified. 

1  Report  of  the  Comptroller  of  the  Currency,  1915,  Vol.  II,  pp. 
744r-745. 


CHAPTER  XVI 

Commercial  Paper  Houses  as  Intermediaries 
BETWEEN  Borrowers  and  Banks 

In  an  earlier  chapter  attention  was  directed  to  the 
rise  and  development  of  our  commercial  paper  or  note 
brokerage  houses  as  important  institutions  in  our 
recent  financial  evolution.  It  will  be  our  purpose  in  the 
present  chapter  to  examine  the  work  and  results, 
merits  and  defects  of  the  note  brokerage  system  with 
special  reference  to  the  present  and  immediate  past. 

Characteristic  Features 

It  will  be  well  at  the  outset  to  familiarize  ourselves 
with  the  outstanding  features  of  a  typical  commercial 
paper  house.  Most  note  brokerage  or  commercial 
paper  houses  represent  the  partnership,  as  distin- 
guished from  the  corporate,  form  of  organization.  The 
corporate  form,  which  has  enjoyed  such  vogue  in  the 
realms  of  transportation,  insurance,  manufactiu*ing 
and  banking,  has  not  found  favor  among  the  dealers  in 
commercial  paper.  The  prevalence  of  the  partnership 
among  commercial  paper  houses  is  attributable  in 
large  part  to  the  fact  that  most  note  brokerage  con- 
cerns are  members  of  one  or  more  stock  exchanges,  the 
rules  of  which  do  not  permit  members  being  incorpor- 
ated. Moreover,  the  partnership  form  of  organization 
is  not  subject  to  objectionable  interference  by  the  state 

260 


COMMERCIAL  PAPER  HOUSES  261 

and  has  the  advantage  of  direct  and  centralized  con- 
trol. The  unlimited  liability  feature  of  the  ordinary 
partnership  is  no  disadvantage  inasmuch  as  our  note 
brokers,  unlike  the  English  bill  brokers,  do  not  endorse 
or  guarantee,  except  in  rare  instances,  the  paper  bought 
and  sold. 

Because  our  paper  houses  buy  paper  outright  a  large 
capital  is  necessary.  When  large  transactions  are 
involved  the  capital  of  the  broker  may  be  inadequate 
and  resort  had  to  borrowing  from  the  banks,  in  which 
ease  the  possession  of  a  comfortable  capital  is  essential. 
A  large  supply  of  capital  is  invaluable  during  a  crisis 
when  conditions  render  difficult  both  the  sale  of  paper 
and  borrowing  from  banks. 

The  ideal  broker  has  selling  facilities  and  sale- 
territory  developed  in  keeping  with  his  capital  and 
bank  connections.  Otherwise  the  borrower  could  not 
lean  heavily  on  the  fair  weather  promises  of  the  dealer 
to  take  care  of  paper  irrespective  of  monetary  and  trade 
conditions.  The  resourcefulness  of  the  broker  is  as  im- 
portant as  his  resources  and  bank  connections.  Young, 
vigorous,  alert  brokers  with  relatively  small  cash  cap- 
ital may  have  cultivated  a  widely  distributed  clientele 
and,  keeping  in  touch  with  the  entire  field,  may  be 
more  able  to  sell  paper  under  adverse  conditions  than 
brokerage  concerns  with  large  bank  balances  and 
superior  borrowing  connections. 

When  the  demand  for  paper  in  the  East  becomes 
inactive,  these  far-seeing  brokers,  feeling  the  pulse 
of  the  market  from  the  home  office  in  New  York, 
Boston  or  Philadelphia,  put  forth  redoubled  effort  in 
distant  but  cultivated  territory  where  money  is  more 


262  BANK  CREDIT 

abundant.*  Even  when  money  is  plethoric  in  localities 
near  at  home  they  direct  their  salesmen  where  paper 
is  less  likely  to  sell,  in  distant  cities  and  towns,  against 
the  time  when  the  near-by  market  may  be  wholly  or 
partly  closed. 

As  a  matter  of  necessity,  the  typical  successful  note 
brokerage  house  has  a  high  rate  of  turnover.  As 
the  profit  hovers  around  a  rate  of  only  one-fourth  of 
one  per  cent,  or  $2.50  per  thousand,  the  turnover  must 
be  very  rapid  to  produce  a  satisfactory  return  on  the 
capital  investment.  It  is  believed  in  good  circles  that 
the  note  brokerage  business  is  one  that  enjoys  an 
extraordinarily  good  return. 

The  Paper 

The  kinds  of  paper  handled  by  the  note  broker, 
which  are  almost  as  various  as  those  taken  over  the 
counters  of  banks  lending  directly  to  their  customers, 
include  single  name  paper,  double  name  trade  paper, 
double  name  when  the  endorser  is  a  director  of  the  bor- 
rowdng  corporation,  collateral  notes,  trade  and  bank 
acceptances. 

Unsecured  single  name  paper,  one  note  broker 
estimates,  constitutes  approximately  half  of  the  total 
handled  by  brokers.  Some  brokers  prefer  to  handle 
single  name  paper  because  of  ease  in  securing  renewals. 
Brokers  watch  maturities  and  replace  maturing  paper 
whenever  possible.  In  the  event  of  renewal  single 
name  paper  obviates  the  necessity  of  securing  endorse- 
ments. 

^  Cf.  William  Post,  The  Loan  and  Credit  Department,  Bulletin, 
American  Institute  of  Bank  Clerks,  Vol.  Ill,  p.  137. 


COMMERCIAL  PAPER  HOUSES  263 

Double  name  trade  paper,  i.  e.,  promissory  notes 
given  in  settlement  for  goods  purchased,  and  endorsed 
by  the  seller,  makes  up  a  very  small  percentage  of 
brokers'  paper,  five  per  cent  being  a  broker's  estimate. 
Non-trade  paper  bearing  endorsement  constitutes,  per- 
haps, 30  or  40  per  cent  of  the  total  bought  and  sold. 
Notes  of  many  of  the  big  textile  mills  are  endorsed  or 
guaranteed  by  the  commission  houses, — many  of  which 
have  an  extraordinarily  high  financial  standing, — 
through  which  they  sell.  WTiere  corporation  officers 
assume  a  personal  liability  through  endorsement  of  a 
corporation's  notes,  it  not  only  shows  the  officers' 
confidence  in  the  stability  and  success  of  the  concern 
but  also  gives  them  a  direct  interest  to  see  that  the 
notes  are  paid.  It  is  regarded  as  sound  practice  to 
give  preference  to  the  paper  of  concerns  whose  in- 
dependent ability  to  pay  seems  unquestionable.  If 
endorsements  are  supplied  in  addition,  it  is  so  much 
the  better. 

Only  a  small  proportion  of  the  total,  probably  not 
more  than  10  per  cent,  is  collateral  loans,  which,  often 
held  by  savings  banks,  are  frequently  renewed. 

The  buyer  of  collateral  paper  may  or  may  not 
depend  upon  the  note  broker  to  keep  the  value  of  col- 
lateral in  satisfactory  relation  to  the  face  of  the  paper. 
If  the  demand  for  additional  collateral  is  not  comphed 
with  the  notes  mature  automatically. 

Trade  and  bank  acceptances  are  new  creations  in 
our  financial  polity  and  constitute  a  small  but  growing 
proportion  of  the  total  volume  of  paper  passing  through 
the  brokerage  channels.  Bank  acceptances,  which  are 
highly  liquid,  command  a  very  low  rate  in  comparison 


264  BANK  CREDIT 

with  the  obligations  of  mercantile  or  manufacturing 
concerns. 

Paper  is  made  in  amounts  running  from  $2,500  to 
very  large  sums.  A  variety  of  denomination  enables 
the  broker  to  meet  the  demands  of  different  customers. 
Small  denominations  like  $2,500  or  $5,000  are  frequently 
employed  because  there  are  many  small  banks  that  have 
very  limited  funds  to  invest  in  outside  paper  and  larger 
banks  with  large  sums  available  for  buying  paper  pre- 
fer to  invest  only  small  amounts  in  the  obligations  of 
one  concern.  A  given  block  of  paper  is,  accordingly, 
generally  spUt  up  into  notes  of  small  denominations. 

As  to  time,  most  brokerage  paper  extends  from  two 
to  eight  months.  The  time  element  generally  depends 
upon  the  needs  of  the  borrower  and  the  condition  of  the 
money  market.  Loans  to  finance  quick  transactions 
or  short-season  goods  should  have  early  maturities. 
If  the  money-market  gives  promise  of  lower  rates  the 
maturity  will  be.  shortened  and  renewal  made  as  a 
means  of  saving'  interest.  If  a  rise  in  the  money 
market  is  foreseen  the  maturity  will  be  lengthened. 

The  Volume  of  Note  Brokerage  Business 

The  writer  has  found  only  a  few  estimates  of  the 
volimie  of  business  carried  on  by  the  note  brokers 
acting  as  intermediaries  between  borrowers  and  banks. 
As  early  as  1906  it  was  estimated  in  banking  circles 
that  upwards  of  $500,000,000  of  commercial  paper  was 
sold  in  the  course  of  a  year  by  the  note  brokers  of  New 
York  City.^    Two  years  later  it  was  estimated  that  the 

1  Samuel  S.  Conover,  The  Credit  Man  in  a  Bank,  Banking  Law 
Journal,  Vol.  XXIII,  No.  4,  April,  1906,  p.  311. 


COMMERCIAL  PAPER  HOUSES  265 

annual  volume  of  such  paper  sold  by  note  brokers 
through  the  country  was  $2,000,000,000.2  No  author- 
itative figures  are  obtainable. 

Ten  Days'  Option 

An  appreciable  part  of  the  large  volume  of  paper 
handled  by  the  brokers  is  sold  on  a  ten  days'  option. 
If  the  purchasing  bank's  investigation  of  the  maker  of 
the  paper  results  favorably  the  paper  is  retained;  if 
unfavorably,  returned.  At  the  time  the  paper  is 
deUvered  to  the  bank  a  cashier's  check  is  given  in  pay- 
ment for  the  proceeds,  i.  e.,  the  face  of  the  note  less  the 
discount  to  maturity.  Should  notes  be  returned  by  the 
bank  as  unsatisfactory,  reimbursement  is  made  by  the 
check  of  the  broker,  allowance  being  made  to  the  bank 
for  the  time  it  has  carried  the  instruments. 

The  Broker's  Profit 

The  note  broker  of  a  generation  ago  performed  a 
different  function  than  does  the  broker  today.  Then 
he  was  a  broker  in  a  strict  sense:  he  took  paper  only 
after  he  had  placed  it,  and  handled  it  for  a  commission. 
Today,  as  has  been  increasingly  the  case  for  about 
twenty-five  years,  the  broker  is  a  dealer:  he  usually 
buys  the  paper  outright  and  takes  the  financial  risk  of 
placing  it  later.  Note  brokerage  houses  in  buying 
paper  outright  do  so  at  a  rate  of  discount  per  annum 
at  which  they  expect  to  sell  the  paper,  and  also  charge 
the  maker  a  flat  commission  of  3^  per  cent  (more  or 
less)  of  the  face  value.    The  broker,  guaranteeing,  as 

2  William  A.  Law,  Cooperation  in  Commercial  Credits,  Proceedings, 
Pennsylvania  Bankers'  Association,  1908,  p.  43. 


266  BANK  CREDIT 

he  does,  the  genuineness  of  the  signature  without 
endorsing  the  paper,  may  make  more  or  less  than 
his  commission.  If  the  market  rate  rises  after  he  has 
purchased  a  given  block  of  paper,  he  may  lose  even 
more  than  the  one-fourth  per  cent  conmiission.  If  the 
market  rate  falls,  he  stands  to  gain  in  proportion.  The 
profit  of  the  broker,  which  is  commonly  but  somewhat 
erroneously  referred  to  as  a  commission,  was  formerly  a 
flat  sum  of  $2.50  per  thousand  dollars.  The  broker's 
remuneration,  nominally  a  commission,  but  often  more 
or  less  than  the  commission,  varies  with  changes  in 
money  rates,  as  we  have  stated,  and  according  to  the 
bargaining  power  of  the  broker  as  he  deals  under 
dynamic  conditions  with  borrowers  on  the  one  hand 
and  with  lending  banks  on  the  other. 

The  commission  of  the  paper  dealer  being  without 
respect  to  the  length  of  time  the  note  has  to  run,  makers 
of  paper  perceived  that  an  advantage  would  be  gained, 
brokers'  commissions  in  the  aggregate  would  be  re- 
duced, through  lengthening  the  maturity  of  notes.  If 
a  given  amount  of  90  day  paper  were  sold  through  a 
broker  four  times  a  year,  four  commissions  would  have 
to  be  paid.  Accordingly,  borrowers  came  to  make 
their  paper  of  longer  and  longer  usance.  The  longer 
the  paper  had  to  run  the  smaller  was  the  commission, 
expressed  in  terms  of  a  percentage  per  annum  of  the 
principal.  The  borrower,  or  maker  of  paper,  always 
and  properly  regards  the  commission  as  a  part  of  the 
interest  paid.  That  is  to  say,  lengthening  the  time 
paper  had  to  run  reduced  the  per  annum  cost  of  the 
services  rendered  by  the  paper  dealer,  thereby  enhanc- 
ing the  power  of  the  paper  dealer  to  compete  success- 


COMMERCIAL  PAPER  HOUSES  267 

fully  with  banks  lending  directly.  It  may  make  for 
clarity  to  point  out  that  one-fourth  of  one  per  cent 
commission  on  a  sixty  day  loan  is  equivalent  to  a  rate 
of  interest  of  one  and  one-half  per  cent  per  annum. 
The  same  rate  of  commission  on  paper  running  six 
months  would  be  equal  to  one-half  of  one  per  cent  per 
anniun.  Long  maturities  ease  the  work  of  the  com- 
mercial paper  house  and  entail  lowered  aggregate  costs 
to  their  borrowing  customers.  Lowered  costs  make  the 
paper  house  a  relatively  attractive  agency  to  borrowers 
in  securing  needed  funds  and  the  longer  paper  has  to 
run  the  wider  becomes  the  possible  disparity  or  spread 
between  brokers'  rates  and  bank  rates.  This  fact, 
which  has  been  pointed  to  as  one  of  the  ''secrets"  of 
the  business,  is  undeniably  responsible  for  the  lengthen- 
ing of  the  average  time  of  loans, — °a  circumstance 
that  tends  to  affect  adversely  the  flexibility  of  the 
bankers'  loan  maturities.^ 

Advantages  of  the  Note  Brokerage  System  to  Borrowers 

The  basic  reason  for  the  rise  and  growth  of  the  note 
broker  is  that  borrowers  found  it  advantageous  to 
float  their  paper  beyond  local  limits,  which  frequently 
confined  their  borrowing  activities  as  to  both  volume 
and  rate.  During  the  last  forty  years  there  has  been  a 
pronounced  increase  in  the  size  of  the  business  unit, 
which  has  not  infrequently  found  its  borrowing  de- 
mands in  excess  of  the  legal  lending  power  of  the  local 
bank.    The  restriction  imposed  by  the  National  Bank 

1  Jos.  T.  Talbert,  Commercial  Paper,  Proceedings,  Nineteenth 
Annual  Convention,  Minnesota  Bankers'  Association,  1908,  pp.  44, 
45. 


268  BANK  CREDIT 

Act  on  loans  to  any  single  borrowing  concern  to  one- 
tenth  of  the  capital  and  surplus  of  the  bank — a  pro- 
vision that  has  its  rough  counterpart  in  many  of  our 
state  banking  statutes — necessitated  resort  to  more 
than  one  bank.  But  it  was  inconvenient  and  unpleas- 
ant to  keep  a  balance  in  each  of  several  banks.  The  de- 
sire to  break  away  from  these  arrangements  prompted 
negotiation  with  the  note  broker  whose  market  in- 
cluded hundreds  of  banks  in  a  score  of  states. 

Local  borrowers  were  impelled  to  resort  to  credit 
facilities  outside  their  communities  also  because  the 
wider  market  commonly  afforded  lower  rates  than 
those  obtainable  at  home.  The  facilities  of  the  note 
broker  enable  the  borrower  to  tap  the  capital  supply 
where  there  is  a  plethora  and  where,  therefore,  the 
rate  rules  low.  The  local  rate  in  St.  Louis  may  at  a 
given  time  be  relatively  high,  in  which  case  St.  Louis 
merchants  and  manufacturers  may  be  put  in  touch 
with  lending  banks  in  Boston  or  other  centers  where  at 
the  time,  at  least,  rates  are  lower.  While  there  is  a 
tendency  toward  equalization  of  rates  among  the 
money  centers,  that  tendency  never  works  itself  out 
completely.  Nevertheless,  in  the  process  of  approxi- 
mate equahzation  of  inter-sectional  rates  the  borrower 
securing  his  funds  tlu-ough  the  note  broker  gains  a  very 
appreciable  advantage  in  rate.  Some  of  our  heaviest 
borrowers  like  John  Wanamaker  and  Armour  and 
Company,  normally  seek  httle  or  no  accomodation  at 
their  local  banks  but  sell  their  paper  in  the  open  mar- 
ket. Having  attained  a  position  where  they  are  not 
dependent  directly  on  the  banks,  they  prefer  to  be 
governed  by  money  conditions  in  the  leading  centers, 


COMMERCIAL  PAPER  HOUSES  269 

rather  than  be  subject  to  credit  influences  within 
narrowly  circumscribed  areas.  The  fact  that  such 
borrowers  sell  their  paper  does  not  imply  that  they  are 
compelled  to  seek  credit  away  from  home  but,  instead, 
that  they  have  attained  the  enviable  position  of  being 
able  to  sell  their  paper  in  those  markets  that  offer  the 
lowest  rates  of  discount. 

There  is  still  another  way  in  which  selling  paper 
through  a  broker  saves  interest.  A  concern  borrowing 
from  a  bank  is  expected,  and  often  required,  to  main- 
tain a  balance  of  approximately  20  per  cent  of  the 
credit  limit  allowed.  What  the  bank  borrower  loses 
in  interest  on  the  idle  deposit  balance  must  be  included 
when  interest  is  reckoned  on  the  loan.  It  makes  little 
difference  in  cost  whether  a  concern  borrows  at  6  per 
cent  and  maintains  no  balance  or  borrows  at  5  per  cent 
and  maintains  a  20  per  cent  balance.  In  other  words, 
the  broker  would  save  the  borrower  interest  even  if  the 
bank  quoted  the  same  rate.  The  commission  of  the 
broker  amounting  to  }/i  per  cent  partially,  but  only 
partially,  offsets  the  economy  afforded  by  the  note 
brokerage    system. 

It  would  be  easy,  however,  to  exaggerate  the  saving 
in  interest  traceable  to  the  fact  that  the  concern  selling 
through  a  note  brokerage  house  is  not  required  to 
maintain  a  substantial  deposit  balance.  Whether  a 
company  borrows  directly  or  through  brokers,  a 
balance  of  some  magnitude  is  normally  on  deposit  for 
safe-keeping  and  in  order  to  facilitate  the  payment  of 
obligations.  A  good  sized  balance  is  conducive  also 
to  friendly  relations  with  the  local  bank,  which  may  be 
needed  in  an  emergency,  when  the  open  market  may  fail. 


270  BANK  CREDIT 

Besides  securing  funds  at  a  lower  rate  and  tapping 
a  greatly  enlarged  number  of  capital  sources,  the  con- 
cern borrowing  through  note  brokers  strengthens  its 
borrowing  position  at  home.  If  paper  stands  the 
investigation  of  alert  credit  men  in  buying  banks  and 
their  correspondent  institutions — to  say  nothing  of 
the  increasingly  thorough  investigation  carried  out  by 
the  credit  departments  of  the  note  brokerage  houses— 
and  lives  in  the  market,  the  local  banker's  good  opin- 
ion of  the  borrower  is  strengthened  and  confirmed. 

Disadvantages  to  the  Borrower 

To  offset  these  numerous  advantages  there  are  two 
clearly  distinguishable  drawbacks.  The  first  is  that  the 
concern  selling  paper  through  a  note  brokerage  house 
thereby  becomes  almost  certainly  the  subject  of  very 
numerous  inquiries.  Banks  that  have  bought  the 
paper  on  option  desiring  information  that  is  not  con- 
tained in  the  statement  or  that  the  broker  cannot  or 
does  not  supply,  communicate  directly  with  the  bor- 
rowing house.  Whether  inquiries  relate  to  pledged 
accounts  receivable,  life  insurance,  contingent  liability, 
financial  worth  of  endorsers,  sales,  bad  debts  charged 
off,  profits,  dividends,  depreciation,  bank  accounts 
and  lines  of  credit  or  to  other  more  or  less  important 
matters,  considerable  work  and  trouble  may  be  oc- 
casioned. 

The  second  disadvantage  is  of  a  questionable  nature: 
the  note  brokerage  system  is  conducive  to  overtrading 
and  over-expansion  on  the  part  of  the  borrower.  As 
this  disadvantage  may  easily  be  avoided  by  the  bor- 
rower, we  shall  treat  it  later  as  a  weakness  of  the  note 


COMMERCIAL  PAPER  HOUSES  271 

brokerage  system,  passing  now  to  a  consideration  of  the 
advantages  of  broker's  paper  to  buying  banks. 

Advantages  of  the  Note  Brokerage  System  to  Banks 

The  broker  is  frequently  of  invaluable  assistance 
to  the  banks.  Bankers  with  surplus  funds  not  only 
welcome  the  broker  with  his  rich  assortment  of  offer- 
ings but  even  seek  him  out,  buying  his  paper  at  a  lower 
rate  of  discount  than  they  would  be  willing  to  quote 
to  their  depositors.  Looked  at  from  this  angle  the 
brokerage  house  is  indeed  an  economical  agency  for 
placing  the  idle  funds  of  banks  in  the  hands  of  those 
who  can  use  them  advantageously.  But  for  the  broker 
in  their  midst,  banks  in  the  larger  cities  would  have 
to  send  capable  and  highly  paid  solicitors  over  the 
country  in  search  of  borrowers.  Country  banks  having 
only  occasional  and  small  amounts  of  idle  funds  might 
find  an  outlet  costly  and  unsatisfactory. 

Surplus  funds  might  be  invested  in  bonds,  but  such 
investment  is  likely  to  shrink  in  principal  at  just  the 
time  the  banker  wants  most  to  realize  on  its  sale,  i.  e.,  in 
a  period  of  stringency  and  high  money  rates.  Bonds 
lack  the  automatic  liquidation  of  well  chosen  commercial 
paper  and  appeal  less  strongly  to  conservative  bankers 
desiring  liquidity  of  assets  than  does  broker's  paper. 

The  purchase  of  broker's  paper  has  several  additional 
advantages.  Not  the  least  of  these  is  the  avoidance  of 
peculiarly  unliquid  loans  that  almost  certainly  result 
when  the  banker,  in  order  to  put  out  idle  funds,  eagerly 
ofifers  money  to  his  local  merchant,  jobber,  or  manu- 
facturer,— to  discount  bills  and  "to  keep  their  indebt- 
edness all  at  home."    In  such  cases  the  borrowers,  after 


272  BANK  CREDIT 

some  thought  as  to  whether  they  can  use  the  additional 
funds  to  advantage,  usually  decide  that  they  can  save 
some  small  discomits  or  expand  their  business  a  little. 
The  money  under  those  circumstances  goes  out  and  the 
banker  later  discovers  that  he  has  made  a  long  time 
loan.^  By  dealing  with  a  note  broker  unliquid  loans  of 
this  character  may  be  happily  avoided. 

The  way  in  which  the  Hartford,  Connecticut,  banks 
coped  with  the  situation  arising  out  of  the  San  Fran- 
cisco earthquake  and  fire  illustrates  nicely  the  value 
of  well  selected  commercial  paper  as  a  quick  bank 
asset.  Hartford  insurance  companies  paid  fire  losses 
of  more  than  S15,000,000,  all  of  which  found  its  way 
out  of  the  city.  The  hea\y  withdrawals,  however, 
were  offset  by  the  maturity  and  pajnnent  to  the  banks 
of  outside  commercial  paper.- 

Within  recent  years  one  of  the  oldest  and  most  con- 
servative trust  companies  in  New  York,  by  carrying 
bills  purchased  equal  to  approximately  50  per  cent  of 
its  deposits  and  by  having  about  two  hundred  and 
fifty  thousand  dollars  of  the  paper  bought  mature 
during  each  business  day  during  certain  months  of  the 
year  enjoyed  the  advantage  of  a  degree  of  hquidity  in 
its  assets  that  enabled  the  institution  to  meet  easily 
extraordinary  demands  whenever  they  occurred.^ 

1  Charles  R.  Hannan,  Uniform  Statement  Blanks,  Proceedings, 
Thirteenth  Annual  Meeting,  Iowa  Bankers'  Association,  1899, 
p.  89. 

2  J.  Harold  Schmidt,  Commercial  Paper,  Bulletin  of  the  American 
Institute  of  Banking,  Vol.  IX,  December,  1907,  p.  532. 

*  J.  Herbert  Case,  The  Desirability  of  Commercial  Paper  as  a  Bank 
Investment,  Proceedings,  Ninth  Annual  Convention,  New  Jersey 
Bankers'  Association,  1912,  p.  32. 


COMMERCIAL  PAPER  HOUSES  273 

Even  local  loans  made  in  the  regular  course  of 
business  are  usually  slow,  often  being  renewed  and  in 
times  of  stringency  are  likely  to  be  increased  rather 
than  liquidated.  One  banker  has  asserted  that  ''the 
only  certainty  about  local  loans  is  that  in  time  of  stress 
they  will  increase  rather  than  be  paid  down.  The 
credit  of  a  local  bon^ower  is  too  narrowly  known  and 
there  is  no  market  for  his  note.  If  perchance  it  is 
[ehgible  for  discount]  ...  at  the  Federal  Reserve  bank 
and  you  rediscount  it,  it  is  you  and  not  the  maker  who 
wUl  worry  about  caring  for  it  at  .  .  .  maturity.  These 
defects  are  .  .  .  inherent  in  local  loans.  To  a  con- 
siderable degree  in  the  average  bank  they  are  a  fixed 
asset."  ^  To  call  a  local  loan  when  the  borrower  is  not 
ready  to  pay  may  cause  inconvenience  or  distress  and 
tends  to  alienate  business.  It  may  be  reported  that  the 
bank  is  ''hard  up."  About  renewing  broker's  paper 
there  is  neither  concern  nor  obligation  and  a  refusal  to 
buy  is  never  a  reflection  on  a  bank's  condition. 

From  the  standpoint  of  any  given  bank  commercial 
paper  bought  from  brokers  is  liquid,  but  from  the 
standpoint  of  the  whole  system  it  is  not  quite  so  liquid 
as  it  first  appears,  being  simply  shifted  to  a  great  ex- 
tent from  bank  to  bank  and  renewed.  The  notes  of 
large  concerns  having  nation-wide  credit  move  from 
bank  to  bank,  but  in  many  instances  they  remain 
relatively  constant  in  volume.^    In  a  very  important 

'  F.  W.  Crane,  Commercial  Paper  Purchased  from  Brokers',  Pro- 
ceedings, Thirty-Sixth  Annual  Convention,  Illinois  Bankers'  Asso- 
ciation, 1916,  pp.  131,  132. 

2  A.  E.  Adams,  As  to  the  Efficiency  of  our  Present  System,  Proceed- 
ings, Twenty  Fourth  Annual  Convention,  Ohio  Bankers'  Associa- 
tion, 1914,  p.  46. 


274  BANK  CREDIT 

sense  such  notes  are  not  liquid,  but  from  the  standpoint 
of  indi\ddual  banks  they  are  highly  so. 

Another  advantage  of  buying  broker's  paper  is  that 
it  enables  the  banker  to  inject  variety  into  his  loans. 
The  danger  of  holding  a  relatively  large  amount  of 
any  one  class  of  loans,  a  danger  particularly  present  in 
the  case  of  many  country  banks,  may  be  avoided  by 
well  made  purchases  of  paper  from  brokers'  hsts.  A 
bank  in  a  timber  country  is  enabled  to  place  in  its 
note  case  paper  other  than  loggers'  or  millmen's  notes; 
in  a  stock  section,  other  than  stock  raisers'  obligations; 
in  an  agricultural  section  variety  may  be  built  up  on 
the  basis  of  farmers'  notes.  Should  deposits  run  down 
from  a  depression  in  the  industry  common  to  the  sec- 
tion it  is  "a  strong  anchor  to  the  windward"  to  have  a 
part  of  the  bank's  funds  invested  in  quarters  not  af- 
fected by  the  depression  at  home.^ 

If  adverse  conditions  prevail  in  certain  lines  of 
business  it  is  possible  gradually  to  curtail  the  volume 
of  paper  originating  in  those  hnes,  and  to  increase  at 
the  same  time  the  holdings  of  paper  in  lines  good  be- 
yond question.  This  is  particularly  true  in  connection 
with  certain  trades  that  are  more  than  commonly 
sensitive  and  hazardous,  such  as  jewelry,  furs,  pianos, 
and  luxiuies  generally.  Whether  times  are  good  or 
bad  loans  made  to  staple  lines,  like  groceries,  staple 
dry  goods,  hardware,  boots  and  shoes,  are  subject  to 
httle  variation  or  loss.^ 

1  A.  L.  Mills,  Dovhtfvl  Banking,  Proceedings,  Oregon  State  Bank- 
ers' Association,  1907,  p.  43. 

2  Cf.  Samuel  S.  Conover,  The  Credit  Man  in  a  Bank,  Banking  Law 
Journal,  Vol.  XXUI,  April,  1906,  p.  311. 


COMMERCIAL  PAPER  HOUSES  275 

Bankers  buying  commercial  paper  are  able  also 
to  obtain  maturities  that  satisfy  their  prospective 
requirements.  If  a  banker  knows  that  he  will  probably 
suffer  a  withdrawal  of  deposits  or  meet  new  demands 
for  loans  at  the  expiration  of  three  months,  he  can  buy 
the  required  amount  of  paper  having  just  the  desired 
maturity,  keeping  his  funds  fully  employed  but  avail- 
able at  the  time  needed.  In  discounting  the  notes  of 
customers  the  banker  feels  obliged  to  meet  their  needs, 
although  the  maturities  may  not  fit  the  requirements  of 
the  bank.  The  assortments  of  the  paper  dealers  are  so 
large  and  so  varied  as  to  maturity — as  well  as  to 
denomination — that  the  banker  may  pick  and  choose. 

Broker's  paper  is  also  very  attractive  to  those  nu- 
merous bankers  who  dislike  to  rediscount  their  own 
customers'  notes.  Broker's  paper  is  of  easy  and  inof- 
fensive convertibility  into  cash  through  the  rediscount 
process.  Moreover,  if  the  banker  desires  to  borrow 
on  his  own  note,  broker's  paper  is  almost  certain  to 
be  more  acceptable  as  collateral  to  the  lending  insti- 
tution than  customer's  paper  would  be. 

It  may  be  pointed  out  as  a  further  advantage  of 
buying  broker's  paper  that  losses  are  lighter  thereon 
than  on  local  loans,  even  though  the  banker  has  the  ad- 
vantage of  knowing  the  loan  record  of  his  customers  and 
the  benefit  of  personal  acquaintance.  The  heavier  losses 
on  local  paper  may  be  explained  on  various  grounds. 

In  the  first  place  it  is  the  practice  everywhere  to 
extend  credit  more  hberally  to  customers  who  main- 
tain deposit  balances  than  would  be  granted  through 
the  purchase  of  their  paper  on  its  merits  in  the  open 
market.    Danger  to  the  banker  lurks  in  his  too  ready 


276  BANK  CREDIT 

recognition  of  his  obligation  to  take  care  of  the  bor- 
rowing needs  of  his  depositors.  Long  years  of  square 
dealing  and  personal  acquaintance  establish  a  confi- 
dence which  would  not  be  warranted  by  a  close  scrutiny 
of  neglected  credit  factors.  In  the  next  place  a  special 
plea  based  upon  emergency  or  mishap  may  cause  the 
banker  to  extend  credit  against  his  own  inchnation  and 
judgment.  A  third  reason  for  the  relatively  heavy 
losses  on  local  loans  may  Ue  in  the  operations  of  the 
note  brokers  themselves,  who  enable  the  borrower  to 
pay  off  his  obligations  to  the  local  bank  by  means 
of  simply  shifting  his  loans  to  other  banks  for  a  while.  ^ 
Losses  on  broker's  paper  are  seldom  disastrous  to  the 
holding  bank,  unless  an  utter  lack  of  discretion  has 
been  shown  in  the  amount  of  one  name  purchased.  It 
is  the  local  loan  that  is  likely  to  get  the  banker  in  be- 
yond his  depth.  Such  losses  as  do  occur  on  broker's 
paper  are  fairly  certain  to  be  more  or  less  evenly  dis- 
tributed in  time  as  well  as  relatively  slight  in  amount. 
Another  advantage  to  the  banker  of  patronizing 
the  commercial  paper  houses  that  seems  worth  noting 
is  that  the  study  of  the  credit  factors  underlying 
broker's  paper  constitutes  a  schooling  that  is  valuable 
when  appUed  to  the  study  of  local  risks.  The  analysis 
of  the  more  complex  conditions  of  distant  borrowers 
affords  both  background  and  guiding  principles  for  a 
more  intelligent  scrutiny  of  risks  right  at  home.  The 
intelligent  buying  of  broker's  paper  makes  for  sounder 
local  loans. 

1  Jos.  T.  Talbert,  Commercial  Credits,  Proceedings,  Fifteenth 
Annual  Convention,  New  York  State  Bankers'  Association,  1908, 
pp.  83,  84. 


COMMERCIAL  PAPER  HOUSES  277 

Disadvantages  to  the  Bank 

What  does  the  banker  have  to  pay  for  these  num- 
erous advantages?  In  the  first  place  he  pays  the  dif- 
ference between  the  relatively  low  and  variable  rate 
obtained  from  investment  in  broker's  paper  and  the 
relatively  high  and  stable  yield  on  '^straight"  paper. 
Just  what  that  difference  is  it  is  impossible  to  say 
with  exactness,  but  the  experience  of  a  prominent, 
and  perchance  a  typical,  bank  in  Illinois  will  throw 
some  light  on  the  question.  A  record  extending  over 
twelve  years  prior  to  1916  showed  an  average  dis- 
count rate  on  broker's  paper  of  4.88  per  cent.  An 
officer  of  the  same  institution  states  that  the  average 
return  from  direct  loans  during  the  same  period  was 
approximately  5.5  per  cent.  But  the  loss  in  earnings 
between  4.88  per  cent  and  5.5  per  cent  is  more  apparent 
than  real,  for  had  it  not  been  for  the  ready  availability 
of  the  broker's  paper  as  a  secondary  reserve  a  larger 
cash  reserve  would  have  been  maintained.  (This 
consideration  is  offset  in  varying  degress  in  individual 
cases  by  the  fact  that  dir^ict  loans  almost  invariably 
result  in  an  increase  in  deposits  for  the  lending  bank.) 
The  convertibility  of  broker's  paper  is  only  one  step 
removed  through  the  process  of  rediscount  from  cash 
itself.  Indeed,  commercial  paper  stood  the  test  of  the 
panic  of  1907  more  creditably  than  did  demand  loans 
backed  by  the  best  collateral  security. 

Weaknesses  of  the  System 

The  most  serious  disadvantage  or  penalties  of  buy- 
ing paper  from  the  note  brokers  do  not  relate,  however, 
to  specific  transactions.     The  operation  of  the  note 


278  BANK  CREDIT 

brokerage  system  as  an  institution  results  at  times  in  a 
loose  but  powerful  regulative  control  over  the  activity 
of  our  banks,  both  in  particular  and  in  the  aggregate, 
that  is  both  far-reaching  and  objectionable.  During 
periods  of  both  easy  and  tight  money  the  influence  of 
the  note  brokerage  houses  on  the  lending  activities  of 
the  banks  is  pronounced.  Dming  times  of  easy  money 
the  brokers  come  forward  as  rivals  of  the  banks ;  during 
periods  of  stringency  they  tend  to  withdi'aw  to  a  high 
retreat,  leaving  the  banks  to  care  for  the  needs — swol- 
len needs — of  customers  returning  from  the  broker's  to 
the  banker's  fold. 

It  has  already  been  said  that  banks  with  surplus 
funds  seek  out  the  broker,  at  least  give  his  representa- 
tive a  cordial  welcome  and,  because  of  a  surplus  of 
funds,  buy  from  the  broker  paper  of  concerns  not 
among  the  banks'  customers  at  a  rate  below  that  which 
the  banks  quote  to  their  local  borrowers.  Now  a 
corollary  is  that  somewhere  another  bank  is  losing  a 
borrowing  customer.  A  Chicago  bank,  let  us  say, 
ha\dng  idle  funds,  buys  the  note  of  a  Grand  Rapids 
concern.  A  Grand  Rapids  bank,  just  having  lost  a 
borrowing  customer,  tends  to  have  money  lying  idle 
and,  seeking  a  natural  outlet  for  its  excessive  funds 
through  the  purchase  of  paper  from  a  broker,  invests 
in  the  obhgations  of  a  New  York  concern,  a  concern 
that  commercial  paper  dealers  have  succeeded  in  di- 
vorcing from  a  New  York  bank.  The  New  York  bank 
in  turn  tends  to  have  idle  cash  available  for  invest- 
ment in  broker's  paper.  The  process  continues  and 
spreads.  The  result  is  that  the  note  broker,  especially 
with  easy  money  prevailing,  comes  to  the  front  as  a 


COMMERCIAL  PAPER  HOUSES  279 

distributor  of  bank  credit,  an  active  competitor  of  the 
banks.  Individual  bankers  purchase  the  notes  offered 
by  the  broker,  even  if  the  rates  of  discount  are  below 
those  quoted  to  their  regular  customers,  in  an  endeavor 
to  prevent  a  break  in  local  rates;  but  brokers'  low  bids 
reach  the  banks'  borrowing  customers  and  the  rates 
on  loans  made  directly  by  the  banks  also  decline. 
Competition  among  banks  and  brokers  assumes  a  cut- 
throat character  and  rates  tend  to  become  unduly 
depressed  during  periods  of  easy  money. 

At  such  times  when  money  is  plentiful  the  broker 
may  send  out  scores  of  telegrams  to  both  those  con- 
cerns whose  accounts  he  handles  and  to  those  whose 
accounts  he  is  soliciting,  offering  funds  at  the  rate  pre- 
vaihng  in  the  lowest  money  market  in  the  country,  plus 
his  commission.^  Note  brokers  frequently  resort  to  un- 
derbidding in  order  to  take  accounts  from  competitors 
or  to  be  able  to  offer  especially  choice  names  that  may 
be  used  to  assist  in  the  sale  of  less  attractive  ones.  A 
broker  thus  threatened  with  the  danger  of  losing  an 
account  naturally  meets  the  bid  and  may  ''go  one 
better."  Demoralization  of  rates  results.  The  situa- 
tion is  analogous  to  the  competition  afforded  conserva- 
tive bankers  by  their  ambitious  neighbors  who  attempt 
to  attract  business  by  the  offer  of  high  rates  of  interest 
on  deposits,  free  collections,  and  more  hberal  credit 
extension.  Among  note  brokers,  however,  the  offend- 
ers are  protected  in  a  measure  against  the  consequences 

'  Thomas  P.  Beal,  Jr.,  Effect  of  Increased  Operations  of  Note 
Brokers  upon  the  Earnings  of  Commercial  Banks,  Proceedings,  Forty- 
second  Annual  Convention,  American  Bankers'  Association,  1916, 
p.  500. 


280  BANK  CREDIT 

of  their  action.  If  rates  fall,  their  low  bids  are  justified; 
if  they  rise  the  margin  of  commission  is  likely  to  be 
adequate  to  protect  them  against  loss.^ 

It  should  not  be  overlooked  that  progressively 
lower  money  rates  result  in  advancing  profits  for  the 
broker.  If  he  buys  paper  today  at  a  discount  of  5 
per  cent  and,  harboring  hopes  of  a  fancy  profit,  counts 
on  selling  the  same  paper  at  4^^  per  cent,  and  the 
rate  in  the  paper  buying  market  drops  to  4^^  per 
cent  before  the  sale  is  made,  the  broker's  profit,  aside 
from  the  commission,  will  be  doubled.  The  broker 
is,  therefore,  always  under  an  inducement,  in  so  far 
as  he  is  able,  to  depress  the  rate  of  discount,  which 
means  to  increase  the  price  at  which  the  stream  of 
paper  passing  through  his  hands  is  sold.  The  rela- 
tion between  falling  discount  rates  and  brokers'  prof- 
its explains  what  is  said  to  have  happened  repeatedly; 
namely,  when  one  or  two  large  banking  institutions 
having  a  superabundance  of  reserve  and  great  eager- 
ness to  get  it  out  have  bought  paper  at  rates  sHghtly 
below  those  current,  their  action  has  been  instantly  com- 
municated by  brokers  to  every  note-buying  market  in  the 
country  and  advantage  taken  of  it  in  order  to  break  the 
rate  in  other  centers.  It  is  plain  that  during  periods  of 
easy  money  banks  with  surplus  funds  are  placed,  through 
the  instrumentality  of  the  note  broker,  at  the  mercy  of 
the  banker  who,  "in  a  moment  of  weakness"  is  willing 
to  buy  a  block  of  paper  at  a  rate  below  the  market.^ 

1  Jos.  T.  Talbert,  Commercial  Credits,  Proceedings,  Nineteenth 
Annual  Convention,  Minnesota  Bankers'  Association,  1908,  p.  46. 

-  Ralph  Van  Vechten,  Proceedings,  Forty-second  Annual  Conven- 
tion American  Bankers'  Association,  1916,  p.  506. 


COMMERCIAL  PAPER  HOUSES  281 

While  the  note  brokerage  system  is  to  be  credited 
with  a  strong  tendency  toward  equalizing  discount 
rates  territorially,  it  must  be  charged  with  accentuating 
differences  in  rates  in  point  of  time.  The  possible 
spread  between  the  rates  of  Newark  and  Kansas  City 
at  any  given  time  has  been  narrowed;  the  difference  be- 
tween the  low  rates  of  a  period  of  easy  money  and  the 
high  rates  prevailing  when  brisk  trade  and  industry 
all  but  outrun  the  volume  of  the  circulating  media  has 
tended  to  become  widened. 

An  outstanding  feature  of  the  expansion  of  the 
work  of  the  note  broker,  particularly  in  times  of  easy 
money,  is  the  anomalous  situation  of  bankers  in 
being  called  upon  to  testify  as  to  the  credit  of  their 
customers  whose  business  may  be  about  to  pass  into 
a  paper  dealer's  hands.  A  Grand  Rapids  banker  long 
ago  voiced  poignantly  the  irony  of  conditions  in  which 
the  banks,  keenly  pressed  by  their  rivals  the  note 
brokers,  become  the  agents,  reluctantly,  for  establish- 
ing a  market  for  and  selling  brokers'  notes. 

I  have  recently  talked  with  a  Chicago  banker  who  be- 
lieves in  the  plan  of  bujdng  paper  from  brokers.  He  says  that 
the  majority  of  his  loans  are  made  in  that  way,  and  I  presume 
the  same  plan  is  followed  by  many  other  metropolitan  bank- 
ers. Getting  a  little  insight  into  that  method,  from  that 
standpoint,  it  is  a  queer  sensation  that  creeps  over  the  bank 
cashier  as  he  opens  the  mail  in  the  morning  and  reads  one 
letter  after  another  inquiring  about  the  standing,  reputation, 
character,  and  responsibility, — of  whom?  The  best  cus- 
tomers he  has  got;  the  very  men  that  he  depends  upon  to 
maintain  his  business,  and  by  whom,  perhaps,  he  has  stood 
in  those  times  of  testing  that  you  speak  about,  in  the  years 


282  BANK  CREDIT 

gone  by,  and  by  whom  he  expects  to  stand  in  the  years  to 
come,  when  those  times  come — and  come  thej^  will.  What 
kind  of  an  answer  is  he  to  dictate  to  his  stenographer  to  write 
back  to  the  banker  in  Chicago  or  New  York  about  that  cus- 
tomer? Give  him  a  good  bill  of  credit,  put  him  in  good 
credit  in  his  local  town?  Why  yes,  he  is  entitled  to  it.  But 
what  does  it  mean?  What  is  that  inquiry  for?  You  know. 
We  have  learned  what  that  inquiry  means.  ^ 

The  unfavorable  influence  of  the  paper  dealers  upon 
the  interests  of  the  banks  through  their  weaning  aw^ay 
many  of  the  banks'  best  borrowing  customers  reaches 
its  culmination  during  a  period  of  stringency  or,  more 
rarely,  crisis.  As  a  stringency  comes  on  bankers  grad- 
ually convert  their  paper  holdings  into  cash,  and  the 
brokers  find  them  unresponsive  and  disinclined  to 
further  bu^dng.  Borrowing  merchants  and  manufac- 
turers finding  the  brokers  unable  to  dispose  of  their 
paper  are  compelled  to  fall  back  upon  their  old  time 
bank  connections  which  may  have  been  kept  open  for 
emergency  at  the  insistence  of  the  brokers  them- 
selves! Bankers  then  as  a  matter  of  local  patriotism 
and  out  of  consideration,  perhaps,  for  hundreds  of  men 
employed  by  the  borrower,  extend  credit  ^  as  freely  as 
the  conditions  of  the  time  permit. 

1  James  R.  Wylie,  Proceedings,  Thirteenth  Annual  Convention, 
Michigan  Bankers'  Association,  1901,  pp.  36,  37. 

2  What  becomes  of  the  proceeds  of  such  loans  is  an  interesting 
and  pertinent  question.  It  has  been  urged  that  the  money  goes 
"straight  into  the  reserve  of  the  foreign  bank."  (James  R.  Wylie, 
op.  cit.,  p.  37.)  That  contention,  however,  overlooks  the  possibihty 
of  counter  currents  of  funds  which  might  hold  in  check  and  even 
more  than  offset  the  tendency  of  the  reserve  of  the  lending  bank  to 
diminish.    To  the  extent  that  the  loan  policy  of  the  lending,  i.  e., 


COMMERCIAL  PAPER  HOUSES  283 

The  note  brokerage  business  has  so  facilitated 
borrowing  in  the  open  market  in  normal  times  that 
credit  is  frequently  granted  too  liberally;  too  liberally 
as  to  both  rate  and  amount.  The  significance  of  abnor- 
mally low  rates  in  this  connection  is  that  they  go 
hand  in  hand  with  a  serious  danger  that  borrowers  will 
be  induced  by  this  lowered  element  of  cost  to  expand 
their  operations  beyond  the  point  of  safety.  The 
difference  in  rates  paid  by  borrowers  in  times  of  easy 
money  and  those  paid  in  periods  of  tight  money  is 
widened  with  the  consequence  that  borrowers  find  ad- 
justment to  stringent  monetary  conditions,  coupled 
with  sagging  prices  for  their  wares,  so  much  the  more 
difficult.  That  many  houses  have  bon-owed  more 
money  through  brokers  than  their  limited  capital 
would  warrant  is  scarcely  open  to  debate. 

There  is  a  very  serious  danger  that  the  man  with 
inadequate  capital  of  his  own  will  regard  borrowed 
money  as  permanent  working  capital,  extend  his  busi- 

local,  bank  is  more  liberal  than  that  of  "  foreign  banks  "  the  tendency 
will  be  for  the  lending  institution  to  lose  its  cash.  To  the  extent  also 
that  the  territory  tributary  to  the  lending  bank  is  a  debtor  section 
and  creditor  sections  served  by  "foreign  banks"  are  able  to  enforce 
collections  during  a  period  of  tight  money,  the  local  bank  will  tend  to 
lose  its  cash  in  favor  of  the  banks  serving  the  creditor  sections.  If  we 
reverse  the  conditions,  however,  we  get  reverse  results.  Whether 
the  proceeds  of  a  loan  the  like  of  which  we  are  considering  go  into 
the  reserve  of  a  "foreign  bank,"  then,  depends  altogether  on  such 
conditions  as  the  lending  policies  of  the  banks  concerned,  relative 
collectible  intersectional  indebtedness,  even  international  exchange 
transactions,  and  perhaps  other  independent  factors.  However,  any 
given  bank  that  expands  its  loans  and  discounts  will  tend  to  lose 
reserve  to  other  banks,  unless  at  the  same  time  the  other  banks 
are  adding  correspondingly  to  their  outstanding  commitments. 


284  BANK  CREDIT 

ness  beyond  prudent  and  safe  limits,  and,  when  disturb- 
ances occur  in  the  business  world,  be  unable  to  meet 
his  obligations  for  borrowed  funds.  The  broker,  in 
contradistinction  to  the  banker,  ordinarily  owns  for 
only  a  short  time  the  paper  which  he  sells  and  has 
accordingly  less  incentive  to  keep  the  volume  of  paper 
sold  for  a  chent  strictly  within  safe  limits.  Besides, 
the  remuneration  of  the  broker,  as  already  stated, 
varies  directly  wdth  the  volume  of  his  sales,  which  in 
turn  are  not  anchored  to  and  limited  by  the  require- 
ment of  a  cash  reserv'e.  "VMien  the  banker,  commonly 
conservative  by  nature  and  training,  would  offer  dis- 
couragement from  expanding  a  business  upon  the  pro- 
ceeds of  paper  maturing  in  four  to  six  months,  the  note 
broker,  mindful  of  his  own  interest,  frequently  takes 
the  contrary  course.  This  would  be  true  if  borrowers 
confined  the  sale  of  their  paper  to  a  single  brokerage 
house.  It  is  more  noticeably  true  where  the  maker 
of  paper  employs  two  or  more  brokerage  houses  in  ad- 
dition, it  may  be,  to  borrowing  directly  from  banks. 

From  what  has  been  said  it  is  plain  that  the  note 
broker  has  greatly  increased  the  difficulties  of  the 
banker  in  holding  borrowers  in  restraint,  in  preventing 
over-trading  and  excessive  indebtedness.  It  has  hap- 
pened, also,  that  the  proceeds  of  notes  have  been 
absorbed  by  the  losses  of  an  obsolescent  and  unprofit- 
able business — until  a  check  on  the  further  issue  of 
paper  has  been  imposed  by  a  restricted  money  market. 
The  banker  who  buys  brokers'  paper  can  no  longer,  as 
was  possible  before  the  advent  of  the  middleman,  test 
his  borrower's  solvency  and  abihty  to  pay  by  insisting 
on  a  seasonal  ''clean  up."     Such  a  ''clean  up"  may 


COMMERCIAL  PAPER  HOUSES  285 

now  be  only  apparent  owing  to  the  wide  and  contin- 
uous market  for  paper  which  makes  it  possible  for  a 
borrower  to  take  up  his  notes  through  the  sale  of 
fresh  obligations  in  other  quarters.  The  paper  dealers, 
in  other  words,  tend  to  promote  reliance  of  the  bor- 
rower upon  the  conimercial  banker  for  permanent  or 
semi-permanent  capital.  How  this  tendency  works 
out  practically  may  be  seen  in  connection  with  one  or 
two  extreme  but  instructive  cases. 

Several  years  ago  a  St.  Louis  concern  failed  owing 
banks  $805,000,  of  which  only  $50,000  was  borrowed 
directly.  The  remainder,  $755,000,  was  sold  from 
one  end  of  the  country  to  the  other  by  note  brokers, 
largely  to  country  banks.  Not  a  note  was  placed  with 
St.  Louis  banks  and  the  concern  owed  the  trade, — an 
important  source  of  credit  information, — next  to 
nothing. 

A  more  recent  as  well  as  more  noteworthy  illus- 
tration is  furnished  by  the  borrowing  operations  of 
the  H.  B.  Claflin  Company  of  New  York,  which  failed 
in  1914.  This  concern,  which  was  one  of  the  largest 
wholesale  dry  goods  houses  in  the  world,  had  affiliated 
with  it  a  manufacturing  concern  and  twenty  or  more 
retail  stores.  The  retail  stores  bought  of  the  wholesale 
house  on  open  account,  until  the  accounts  reached  cer- 
tain amounts  when  notes  would  be  given  in  payment  of 
the  accounts.  These  notes  the  H.  B,  Claflin  Company 
would  endorse  and  steadily  offer  for  discount  over  a 
wide  area,  generally  through  note  brokers.  As  to  the 
amoimt  of  endorsed  paper  outstanding  at  any  time, 
brokers,  fearful  of  losing  the  lucrative  business,  were 
reluctant  to  inquire  and  bankers  only  guessed.     The 


286  BANK  CREDIT 

key  to  the  explanation  of  the  willingness  of  bankers  to 
buy  paper  offered  under  such  uncertain  conditions  was 
the  personal  esteem  in  which  ]\Ir.  H.  B.  Claflin,  the 
head  of  the  concern,  was  held.  One  of  the  foremost 
citizens  of  the  metropolis,  of  unquestioned  integrity 
and  business  capacity,  he  had  cultivated  a  personal 
acquaintance  with  prominent  bankers  over  extensive 
territory. 

It  was  known  that  "everybody"  held  Claflin  paper 
and  it  developed  at  the  time  of  the  failure  that  the 
"Claflin  receivables  or  endorsements"  were  diffused 
among  2000  to  3000  banks. ^  "If  everybody  wants 
the  paper,"  the  bankers  seem  to  have  reasoned,  "it 
must  be  good."  The  very  knowledge  that  everyone 
else  is  carrying  the  paper  of  a  given  house  that  a  banker 
thinks  well  of  is  a  source  of  satisfaction  to  him.  If 
failure  should  occur  others  would  share  his  disappoint- 
ment. 

In  June,  1914,  with  tight  money  prevaihng,  the 
concern  was  unable  to  market  more  paper  through  its 
brokers  and  asked  for  temporary  additional  assistance 
from  its  bankers.  The  bankers  interested  cooperated 
in  making  an  examination  of  the  offairs  of  the  com- 
pany, uncovering  direct  indebtedness  of  $9,000,000 
and  contingent  liabiUties  of  almost  $32,000,000,  repre- 
senting the  endorsed  notes  of  the  retail  stores,  the  con- 
dition of  which  was  a  depressing  revelation  to  the 
bankers  concerned.  Quick  assets  amounted  to  approx- 
imately $12,000,000.  In  spite  of  having  long  paid 
five  or  six  per  cent  dividends  the  concern  had  been 
insolvent  for  several  years.  The  note  brokerage  system 
1  Trust  Companies,  July,  1914,  Vol.  XVIII,  p.  6. 


COMMERCIAL  PAPER  HOUSES  287 

had  prolonged  the  Hfe  of  the  company  at  the  expense 
of  the  banka. 

Correctives 

One  method  of  eliminating  the  disastrous  competi- 
tion that  the  note  brokers  generate  would  consist  in 
banks  withholding  credit  information  sought  by  other 
institutions  for  use  in  passing  judgment  upon  broker's 
paper.  A  bank  in  Philadelphia  in  considering  the  pur- 
chase of  broker's  paper  issued  by  one  of  the  customers 
of  a  Baltimore  bank  verj'-  naturally  makes  inquiry  of 
the  credit  department  of  the  Baltimore  bank  as  to  the 
character,  financial  standing,  etc.,  of  the  firm  or  cor- 
poration the  purchase  of  whose  note  is  under  consider- 
ation. If  the  Baltimore  banker,  and  other  bankers 
similarly,  were  to  withhold  the  information  sought  it 
would  be  Hke  throwing  sand  in  the  bearings  of  the 
otherwise  smoothly  running  note  brokerage  machinery. 
Such  a  procedure,  resorted  to  as  a  corrective  of  the 
over-weening  tendency  of  note  brokers,  especially  in 
times  of  monetary  ease,  is  incompatible,  however,  with 
the  present  cordial  relations  among  bankers,  might 
curtail  unquestionably  fair  and  legitimate  note  broker- 
age activity,  and  would  probably  interfere  seriously 
with  the  exchange  of  credit  information  desired  in 
connection  with  the  determination  of  the  quality  of 
non-brokerage  paper.  ^ 

Another  corrective  of  the  unfavorable  influence 
of  the  paper  dealers  which  results  in  semi-demoraliza- 
tion of  interest  rates  and  over-expansion  of  operations 

*  Proceedings,  Forty-second  Annual  Convention,  American  Bank- 
ers' Association,  1916,  pp.  506,  507,  508. 


288  BANK  CREDIT 

on  the  part  of  borrowers  in  periods  of  cheap  money, 
merits  serious  consideration.  Let  the  banker,  it  is 
urged,  educate  his  customer  to  appreciate  the  personal 
character  of  their  mutual  relations  and  the  value  of  the 
willingness  of  the  banker  to  be  of  the  greatest  service 
in  case  of  need.  Even  more  important  than  this,  it  is 
essential  to  drive  into  the  minds  of  borrowers  the 
difference  between  paper  that  is  given  to  a  broker  and 
that  which  is  discounted  at  a  bank.  Paper  discounted 
at  a  bank  may  be  renewed  at  maturity  if  the  borrower's 
deposits  have  been  satisfactory  and  his  credit  is  still 
good,  even  though  reserves  are  low ;  paper  sold  through 
a  broker  may  be  renewed  and  it  may  not.  It  depends 
on  whether  the  broker  is  able  to  market  the  renewal 
paper  or  is  strong  enough  to  carry  it.  Borrowers 
should  be  reminded  tactfully  that,  by  forcing  their 
banks  to  lend  to  them  at  rates  quoted  on  "commer- 
cial" paper,  they  are  actually  obtaining  from  the  bank 
an  insurance  against  times  of  trouble  without  paying 
for  it.^ 

StUl  another  remedy  for  the  feverish  and  disturbing 
activity  of  note  brokers  at  times  when  the  existence  of 
surplus  loanable  funds  delivers  the  bankers  into  their 
hands  is  greater  carefulness  and  watchfulness  in  the 
selection  of  paper  by  the  banks.  The  banker  should  be 
so  insistent  with  reference  to  requiring  statements  of 
condition  in  all  cases  where  paper  is  offered  for  sale,  so 
closely  vigilant  of  the  moral  standing  and  so  persistent 

*  Cf.  Thomas  P.  Beal,  Jr.,  Effect  of  Increased  Operations  of  Note 
Brokers  upon  the  Earnings  of  Commercial  Banks,  Proceedings,  Forty- 
Second  Annual  Convention,  American  Bankers'  Association,  1916, 
p.  504, 


COMMERCIAL  PAPER  HOUSES  289 

in  checking  up  borrowings  as  to  ''shut  and  bar  the 
door"  against  unsafe  and  overexpanded  makers  of 
paper. 

Many  of  the  most  serious  disappointments  bankers 
have  had  with  brokerage  paper  have  resulted  from  the 
purchase  of  notes  whose  makers  failed  to  submit  aud- 
ited statements  through  their  brokers  to  buyers.  Cer- 
tain failures  occurring  in  1913,  have  been  investigated 
carefully  by  a  prominent  Chicago  banker^  whose  find- 
ings are  pertinent  and  instructive. 

The  year  1913  was  marked  by  a  protracted  period 
of  stringent  money  and  a  gradual  retirement  of  paper 
issued  through  commercial  paper  houses.  The  liquida- 
tion of  the  paper,  which  caused  much  inconvenience 
and  heavy  business  mortality,  placed  a  heavy  strain 
on  the  commercial  paper  houses  and  was  effected  only 
after  the  banks  took  on  lines  of  credit  from  their  cus- 
tomers out  of  all  proportion  to  their  previous  agree- 
ments, preventing  thereby  what  might  have  been 
serious  disaster.  As  it  was,  there  were  numerous  fail- 
ures of  houses  unable  to  secure  accommodation  at  their 
banks  sufficient  to  relieve  their  over-extended  condition. 

Note  brokers  and  bankers  were  in  a  large  measure 
responsible  for  the  over-extension  that  led  to  failure. 
The  ease  with  which  flotations  of  paper  could  be  made 
through  note  brokers,  without  proper  restrictions  being 
thrown  around  the  issuance  of  statements,  was  respon- 
sible for  many  of  the  largest  failures. 

Insistence  by  note  brokers  and  bankers  upon  care- 
fully audited  statements  would  have  obviated  most 

'  Ralph  Van  Vechten,  Proceedings,  Thirty-ninth  Annual  Conven- 
tion, American  Bankers'  Association,  1913,  pp.  518,  519. 


290  BANK  CREDIT 

of  the  trouble.  Fifteen  failures  out  of  twenty  one  were 
due  to  over-extended  credit.  Two  were  caused  by  dry 
rot,  poor  business  and  poor  management.  One  case 
was  the  result  of  labor  troubles  combined  with  poor 
business.  One  was  due  to  internal  dissensions.  In 
another,  the  working  capital  had  long  been  employed 
by  the  largest  stockholder  in  private  operations.  One 
failure  was  the  result  of  flood  conditions  in  the  Ohio 
Valley.  In  the  entire  list  there  was  only  one  case  of  an 
audited  statement,  and  the  failure  of  that  company  was 
the  result  of  an  unforeseen  disaster.  Only  one  name  in 
the  entire  Ust  would  have  been  purchased  if  the  note 
brokers  or  buying  banks  had  insisted  upon  the  pur- 
chase of  only  those  notes  w^hose  makers  submitted 
audited  statements. 

Inasmuch  as  bankers  frequently  give  preference 
to  the  paper  of  those  houses  whose  accounts  are 
audited  and  certified  to  by  independent  accountants, 
it  seems  reasonable  to  expect  that  the  present  tendency 
of  bankers  to  insist  more  and  more  upon  audited  state- 
ments from  makers  of  paper  will  continue. 

In  addition  to  the  insistence  of  bankers  and  note 
brokers  upon  audits  by  chartered  accountants  of  recog- 
nized character  and  abiUty  there  should  be  a  friendly 
and  intelligent  cooperation  between  note  brokers  and 
the  bankers  who  carry  the  accounts  of  concerns  floating 
paper  in  the  open  market.  Frequent  comparisons 
could  be  made  and  over-extension  prevented.  The 
same  desirable  end  would  be  favored  by  close  coopera- 
tion among  national,  state  and  clearing  house  examin- 
ing authorities  with  reference  to  lines  of  credit  having 
an  extensive  market. 


COMMERCIAL  PAPER  HOUSES  291 

The  registration  of  commercial  paper  as  a  method  of 
preventing  its  over-issue  was  widely  discussed  a  few 
years  ago,  after  the  panic  of  1907,  and  was  hailed  as  a 
great  forward  movement  advantageous  to  both  bor- 
rowers and  lenders,  saving  time  in  the  inquiry  of 
buying  banks  and  resulting,  it  was  contended,  in  a 
favorable  rate  to  the  borrower  because  of  the  full  and 
definite  knowledge  obtainable  with  reference  to  the 
amount  of  paper  outstanding.^ 

The  details  of  registering  commercial  paper  are 
simple.  Registration  requires  a  resolution  of  the 
board  of  directors  of  a  concern  about  to  have  its  paper 
registered,  affirming  that  all  notes  signed  or  endorsed 
by  the  company  and  all  drafts  and  bills  of  exchange 
accepted  in  the  name  of  the  company  in  order  to  be 
vahd  must  be  registered  by  a  trust  company  and 
the  registration  noted  on  the  paper  itself  over  the 
signature  of  an  officer  of  the  trust  company.  The 
trust  company  is  authorized  and  directed  to  keep  a 
record  of  all  registrations,  including  amounts,  maturi- 
ties, and  any  other  detail  necessary  to  identify  the 
paper.  The  trust  company  is  also  instructed  to  furnish 
any  bank,  banker  or  trust  company,  upon  request,  a 
statement  of  the  amount  of  unmatured  registered  paper. 
In  principle,  the  registration  of  commercial  paper  is 
similar  to  the  registering  of  corporate  stocks  and  bonds. 

Wide  pubhcity  which  was  given  the  registration 
of  the  short-time  obhgations  of  the  International  Paper 
Company  with  the  Bankers  Trust  Company  of  New 

1  Owen  Shepperd,  Commercial  Paper  Registration,  Trust  Com- 
panies, Vol.  12,  No.  3,  March,  1911,  pp.  178-182;  also  ibid.,  p.  271, 
and  New  York  Bankers'  Magazine,  Vol.  82,  May,  1911,  p.  572. 


292  BANK  CREDIT 

York,  Febniarj^  1,  1911,  and  the  announcement  of 
facilities  for  registration  by  other  prominent  financial 
institutions  has  made  little  impression  upon  our  great 
borrowing  concerns  and  the  movement  has  made  no 
substantial  progress,  receiving  meager  support,  even 
positive  opposition,  from  borrowers  and  note  brokers. 
The  note  broker,  sensible  of  having  served  as  a  reposi- 
tory of  information  relating  to  his  clients'  affairs  in  the 
past  and  having  no  liking  for  red  tape,  refused  to  give 
the  movement  his  support.  The  borrower  objected  to 
registration  because  it  might  disclose  to  competitors 
his  lack  of  capital,  his  volume  of  business  or  other  facts 
that  might  be  detrimental  to  him. 

The  advantages  of  registration  to  the  bank  buying 
commercial  paper  are  so  pronounced  that  it  is  hoped 
the  movement  will  not  fail.  Forged  or  spurious  paper 
could  scarcely  pass  undetected  through  the  registering 
trust  company,  where  signatures  of  the  officials  of  the 
issuing  corporation  would  be  on  file.  The  issue  of 
unauthorized  paper  would  also  be  forestalled.  The 
amount  of  paper  outstanding  would  always  tally  with 
the  amount  on  the  signed  statement.  Over-expansion 
would  be  rendered  difficult  and  flagrant  over-issue  of 
paper,  such  as  occurred  in  connection  with  the  Claflin 
failure,  scarcely  possible. 

If  the  obstacles  in  the  way  of  formal  registration 
should  prove  insuperable,  a  closer  cooperation  be- 
tween note  brokers  and  banks  might  result  in  a  greatly 
modified  form  of  registration  that  would  be  simple, 
effective,  and  acceptable  to  all  concerned.  If  concerns 
issuing  paper  would  make  statements  to  their  respec- 
tive bankers  and  to  banks  where  the  notes  are  payable 


COMMERCIAL  PAPER  HOUSES  293 

of  the  amounts  and  maturities  of  paper  outstanding 
at  the  time  of  issue,  instead  of  a  short  time  in  advance 
of  maturity,  as  is  now  customary,  the  objections  to 
registration  that  it  would  permit  of  too  much  pubhcity 
and  involve  objectionable  red  tape  would  be,  in  large 
measure,  overcome.  The  borrower's  own  bank  would 
always  be  in  possession  of  the  amount  of  paper  out- 
standing and  where  there  were  two  or  more  payer 
banks  an  exchange  of  information  would  be  just  as 
easy  as  it  is  today  between  banks  that  have  accounts 
and  Hues  of  credit  in  common.  The  adoption  of  the 
recommendation  would  encourage  makers  of  commer- 
cial paper  who  do  not  maintain  accounts  in  banks 
located  in  the  large  cities  to  establish  banking  connec- 
tions in  the  important  centers,  thus  fortifying  them- 
selves by  providing  additional  bank  accommodation 
against  emergency  or  need.  If  they  preferred,  they 
could  arrange  through  their  home  banks  to  have  their 
paper  made  payable  to  the  latter's  city  correspondent, 
with  the  understanding  that  the  city  correspondent 
would  keep  the  local  bank  informed  of  the  volume  of 
paper  outstanding  at  all  times.  ^  Change  has  come  so 
fast  in  our  lending  methods  during  the  last  decade  that 
it  is  perhaps  not  too  much  to  expect  that  proper  safe- 
guards will  be  thrown  around  the  commercial  paper 
passing  through  the  hands  of  dealers,  and  particularly 
in  so  far  as  the  problem  relates  to  placing  prospective 
buyers  of  paper  in  a  position  readily  to  find  out  the 
amount  of  paper  outstanding  in  any  given  case. 

In  brief,  the  reestablishment  of  a  cooperative  spirit 

1  Ralph  Van  Vechten,  Proceedings  Thirty  Ninth  Annual  Con- 
vention, American  Bankers'  Association,  1913,  pp.  520,  521. 


294  BANK  CREDIT 

and  friendly  personal  relations  between  banks  and 
their  borrowers,  combined  with  more  searching  and 
exacting  methods  of  investigation  by  the  banks,  and 
close  cooperation  between  note  brokers  and  banks, 
would  tend  to  curb  over-expansion  and  to  stabilize 
interest  rates  by  keeping  the  operations  of  the  note 
brokers  within  bounds.  The  result  would  be  a  slightly 
higher  interest  rate  when  rates  were  low  and  a  lower 
rate  when  rates  were  high.  JMeanwhile  the  business  of 
the  note  brokerage  houses  would  not  be  wiped  out. 
Like  the  rates  on  paper  passing  over  their  counters  the 
volume  of  their  business  would  itself  be  more  stable 
and  uniform. 


CHAPTER  XVII 

Bank  Supekvision  in  Relation  to  Bank 
Credit 

The  most  valuable  service  of  a  bank  examiner  has 
to  do  with  his  wholesome  influence  on  the  quality  and 
volume  of  the  loans  of  the  institutions  supervised.  By 
enabhng  banks  under  his  jurisdiction  to  avoid  unsafe 
and  dangerous  loans  the  examiner  renders  a  valuable 
service  not  only  to  the  banks  concerned  but  also  to  the 
business  community  as  a  whole.  In  so  far  as  he  tends 
to  keep  the  crucial  ratio  of  reserve  to  deposits  safe 
and  within  the  limits  of  prudence  he  checks  general 
over-expansion  of  bank  credit.  To  the  extent  that  he 
prevents  and  reduces  loans  extended  to  unsound  credit 
risks,  he  promotes  an  equitable  distribution  of  avail- 
able funds  among  the  most  efficient  and  worthy  bor- 
rowers. In  safeguarding  the  quality  of  bank  loans  the 
examiner  is  an  increasingly  important  and  welcome  ally 
of  the  bank  credit  man. 

Bank  examinations  in  the  United  States  are  either 
''external"  or  "internal."  External  examinations 
have  their  inception  in  agencies  outside  the  bank  such 
as  the  national  or  state  governments  or  clearing  house 
associations.  They  are  precautionary  and  protective 
measures  designed  to  minimize,  if  not  wholly  to  pre- 
vent, banking  practices  and  conditions  inimical  to  the 
interests  of  the  public  in  general  or  groups  of  banks 
in  particular.     The  object  of  external  examinations, 

295 


296  BANK  CREDIT 

like  the  initiative  taken,  is  public  or  quasi-public 
in  character.  Internal  examinations,  on  the  contrary, 
are  pri\'ate  in  nature  and  restricted  in  scope  to  the 
work  and  condition  of  the  institution  examined.  The 
purpose  of  an  internal  examination  is  to  correct  and 
eliminate  practices  that  run  counter  to  the  interests  of 
the  shareholders  of  the  bank  affected.  Internal  exam- 
inations are  exemplified  by  those  conducted  by  bank 
directors  and  those  by  pubhc  accountants  employed 
directly  by  banking  institutions. 

Examinations  in  most  leading  countries  such  as 
England,  Scotland,  Germany,  France,  and  Canada,  are 
internal;  in  the  United  States  prevaiHngly,  but  not 
exclusively,  external.  In  our  own  country,  with  its 
decentrahzed  banking  system,  developments  in  recent 
years  in  connection  with  bank  examination  and  super- 
\'ision  have  had  striking  and  pronounced  effects  upon 
the  distribution  of  credit  extended  by  banks  to  their 
borrowing  customers.  It  will  be  convenient  to  con- 
sider first  the  supervision  of  national  banks  in  relation 
to  the  quality  and  distribution  of  their  loans. 

National  Bank  Supervision 

Thanks  to  the  energetic  and  constinictive  efforts 
of  the  Comptrollers  of  the  currency  and  to  statutory 
changes,  a  transformation  in  the  methods  and  effec- 
tiveness of  national  bank  supervision  was  made  during 
the  decade  following  the  crisis  of  1907.  Pre\'iously 
examiners,  inadequate  in  number,  compensated  on  a 
fee  basis,  and  drawn  in  many  cases  from  the  ranks  of 
those  without  actual  accounting  experience,  did  their 
work    hurriedly,    inefficiently    and    without    special 


BANK  SUPERVISION  297 

leference  to  the  soundness  and  liquidity  of  bank  loans. 
Examiners  had  for  years  worked  in  the  same  district, 
conferred  with  nobody,  each  following  his  own  meth- 
ods, which  were  often  faulty  and  crude,  knowing  very 
little  of  borrowers'  standings  and  the  value  of  secur- 
ities. The  pooling  of  credit  information  as  well  as 
cooperation  in  other  forms  among  the  examiners 
themselves  and  between  the  examiners  and  the  Comp- 
troller's office  was  almost  entirely  lacking.  The  need 
of  such  cooperation  had  clearly  developed. 

In  the  reorganization  of  the  service  by  Comptroller 
Murray  subsequently  to  the  panic  of  1907  the  country 
was  divided  into  eleven  districts;  one  of  the  very  best 
examiners  in  the  work  being  named  as  chairman  of  each 
district,  and  the  examiners  of  each  district  being  re- 
quired to  attend  a  joint  meeting  in  their  district  at 
least  twice  a  year. 

The  meetings  not  only  afford  opportunity  for  the 
discussion  of  such  matters  as  the  adoption  of  new 
forms  and  blanks,  good  and  bad  banking  practices, 
good  and  bad  bankers,  but  are  clearing  houses  for  the 
exchange  of  credit  information. 

Reports  are  rendered  at  the  meetings  by  each 
examiner  on  every  bank  in  his  district  which  he  regards 
as  in  an  unsound  condition.  From  all  the  reports  of 
the  individual  examiners  the  chairman  makes  up  a  final 
report,  copies  of  which  are  mailed  to  the  Comptroller 
and  to  each  of  the  other  district  chairmen  for  their 
information  and  for  the  information  of  examiners  in 
other  districts. 

A  credit  bureau  has  been  built  up  in  the  Comp- 
troller's office  on  the  basis  of  facts  submitted  in  the 


298  BANK  CREDIT 

reports  made  by  the  district  chairman.  Furthermore, 
as  a  copy  of  the  report  of  each  chairman  is  sent  to  each 
of  the  other  chairmen,  and  as  the  reports  are  accessible 
to  the  individual  examiners,  it  is  possible  for  any  exam- 
iner who  is  interested  in  any  particular  line  of  credit  to 
find  out  through  his  chairman  what  the  other  ten 
chairmen  know  about  the  subject  of  his  inquiry.^ 

Another  improvement  in  the  national  examining 
service  was  the  appointment  of  a  number  of  examiners 
at  large.  The  time  of  these  special  examiners  has  been 
devoted  largely  to  banks  which  had  been  under  severe 
criticism  for  years,  the  regular  examiner  being  unable 
to  cope  with  them,  either  because  of  lack  of  time  or 
lack  of  force  of  character.  This  class  of  banks,  given 
to  chronic  disorder,  has  been  put  into  satisfactory  con- 
dition. 

The  examiners  at  large  have  another  and  equally 
important  function.  Going  all  over  the  United  States, 
examining  banks  in  different  districts,  they  are  re- 
quired to  report  to  the  Comptroller  whether  the  regular 
examiners  are  doing  their  work  carefully  and  satisfac- 
torily. They  are  not  only  examiners  of  banks  which 
most  imperatively  call  for  tactful  and  thorough  treat- 
ment but  are  also  supervisors  of  the  ordinary  examin- 
ers.^ 

The  general  relations  of  examiners  to  banks  are  now 
quite  satisfactory.  Examiners  are  no  longer  permitted 
to  borrow  from  national  banks:  to  own  stock  in  a 

^  Lawrence  0.  Murray,  Some  Problems  of  the  Comptroller's  Office, 
Proceedings,  Thirty  Fifth  Annual  Convention,  American  Bankers' 
Association,  1909,  p.  165. 

2  Ibid.,  p.  170. 


BANK  SUPERVISION  299 

national  bank;  to  serve  as  officers  or  directors  of  any 
corporations  which  borrow  from  a  national  bank;  to 
engage  in  any  business  except  examining  banks.  ^ 

The  modifications  of  the  methods  and  machinery 
of  national  bank  supervision  introduced  under  the 
direction  of  the  Comptroller  of  the  Currency  have 
been  supplemented  by  improvements  provided  for  by 
the  Federal  Reserve  Act.  That  statute  placed  national 
bank  examiners  on  a  salary  basis  of  compensation, 
insuring  examination  more  nearly  adequate  and  equal 
to  the  actual  and  varying  requirements  of  institutions 
of  whatever  size  and  condition.  It  is,  however,  not 
the  invariable  testimony  of  bankers  that  the  operation 
of  the  provisions  of  the  act  of  1913  relating  to  bank 
supervision  has  resulted  in  greater  effort  and  suc- 
cess on  the  part  of  examiners  to  tone  up  the  character 
of  the  contents  of  the  note  case.  Politics,  bankers 
contend,  bring  into  the  examining  service  individuals 
who,  good  party  men  that  they  may  be,  are  inefficient 
as  auditors  and  appraisers. 

State  Bank  Supervision  in  Relation  to  Bank  Loans 

Improvement  in  the  work  of  bank  examination 
carried  on  by  the  states  has  been  scarcely  less  marked 
than  that  under  the  control  of  the  Comptroller  of  the 
Currency.  It  would  carry  us  too  far  afield  to  give  a  de- 
tailed description  of  the  work  of  the  progress  made  by 
the  various  states, — but  instead  we  may  well  indicate 
what  has  been  done  in  an  exemplary  manner  by  one  or 
two  of  the  leading  states,  notably  New  York,  by  way  of 

1  Ibid.,  p.  166. 


300  BANK  CREDIT 

purging  the  contents  of  the  banks'  portfoHos  of  inferior 
and  worthless  paper.  The  supervision  of  New  York 
State  banks  is  serving  as  a  guide  to  the  banking  de- 
partments of  other  states  and  deserves  attention  be- 
cause of  the  numerous  and  important  measures  that 
have  been  taken  to  raise  the  quahty  of  bank  loans. 

We  may  mention  first  the  establishment  in  1911  of 
a  credit  bureau.^  A  record  is  there  kept  of  borrowers 
of  large  amounts  in  state  institutions,  of  group  loans, 
persons  borrowing  through  the  use  of  corporate  title 
and  trade  names  in  order  to  secure  '^ extra"  accommo- 
dation, of  dummy  borrowers,  of  bank  stock  hypo- 
thecations,— hjrpothecations  that  indicate  w^hether  the 
stock  is  lodged  in  strong  or  weak  hands  and  if  the 
control  of  the  institution  is  carried  on  borrowed  money. 
The  credit  bureau  furnishes  the  banking  department 
a  check  on  irresponsible  borrowers  and  on  the  activities 
of  ambitious  promoters  who  purchase  control  of  banks 
in  order  to  obtain  additional  facilities  to  further  their 
own  speculations.  But  the  principal  work  of  the  credit 
bureau  is  the  investigation  of  over-extended  borrowers, 
who,  employing  false  statements,  secure  accommoda- 
tion from  a  number  of  institutions,  each  institution 
making  a  loan  upon  the  assumption  that  there  are  no 
other  lending  banks  involved.  One  case  was  found  in 
which  the  borrower  maintained  accounts  in  twenty- 
nine  banks,  and  one  individual  w^as  discovered  borrow- 
ing in  the  name  of  thirty  individuals  and  corporations. 
The  banking  department  of  New  York  State  is  able 
upon  request  to  furnish  to  banks  under  its  supervision 

1  Annual  Report  of  the  Superintendent  of  Banks,  New  York, 
1912,  p.  8.    Same  for  1915,  p.  16;  for  1916,  pp.  15,  16. 


BANK  SUPERVISION  301 

the  total  of  a  borrower's  bank  loans  and  the  number  of 
State  institutions  lending  to  the  borrower,  without,  of 
course,  disclosing  the  names  of  the  lending  banks.  ^ 

The  State  bank  department  of  Indiana  also  keeps 
a  record  of  all  loans  in  excess  of  $2,500;  which  in- 
cludes paper  bought  of  brokers.  The  benefit  to  the 
banks  of  this  credit  information  is  illustrated  by  the 
case  of  a  manufacturing  company  that  sold  $134,000 
of  commercial  paper  to  Indiana  banks.  The  depart- 
ment felt,  after  investigation,  that  the  amount  was 
excessive,  and  the  banks  were  informed,  upon  inquiry, 
of  the  total  amount  borrowed.  Within  a  few  months 
when  the  company  went  into  the  hands  of  a  receiver 
the  concern  owed  the  banks  only  $40,000  and  half  of 
that  amount  was  additionally  secured.^ 

Another  movement  in  the  direction  of  improving 
the  loans  of  New  York  State  banks  is  the  simultaneous 
examination,  in  cooperation  with  the  Federal  examin- 
ers, of  all  the  banks  in  a  given  district.  The  principal 
object  of  the  simultaneous  examinations  is  to  obtain 
the  best  possible  information  concerning  borrowers 
that  is  available  for  the  credit  files  of  the  banking  de- 
partment. The  best  information  cannot  readily  be 
secured  when  the  banks  are  examined  separately  and 
at  different  periods  of  time.^ 

Cooperation  between  state  and  federal  examiners, 

1  Ibid.,  1912,  pp.  8-10. 

2  W.  H.  O'Brien,  Observations  on  Bank  Examinations,  Proceed- 
ings, Sixteenth  Annual  Convention,  Indiana  Bankers'  Association, 

1912,  p.  177. 

» Annual  Report  of  the  Superintendent  of  Banks,  New  York, 

1913,  p.  11. 


302  BANK  CREDIT 

begun  in  1908,  is  now  the  rule.  A  conference  of  the 
examiners  after  the  examination  tends  to  bring  to  hght 
the  true  condition  of  the  affairs  of  the  banks  through  an 
exchange  of  credit  and  other  information.^  Clearing 
house  bank  examiners  are  also  cooperating  with  both 
state  and  federal  authorities,  this  cooperation  taking 
the  form  chiefly  of  attempting  to  discover  and  repress 
"double"  and  ''multiple"  borrowers. 

Clearing  House  Bank  Examination  in  Relation  to  the 
Quality  cf  Bank  Loans 

Clearing  house  examinations,  wherever  introduced 
and  efficiently  administered  can  and  will  by  their 
restraining  influence  reduce  the  evils  of  bad  judgment 
and  dishonesty  to  a  minimum  and  effectually  prevent 
any  general  condition  of  unsoundness  or  of  bad  banking, 
just  as  certainly  as  modern  sanitation,  isolation  and 
health  inspection  may  be  depended  upon  to  prevent 
the  serious  spread  of  contagious  diseases.  An  occa- 
sional death  may  occur,  but  there  can  be  no  epidemic.^ 

"Wliat  is  clearing  house  bank  examination?  Where 
is  it  in  operation  and  in  what  ways  does  its  operation 
affect  the  quaUty  of  the  paper  which  the  borrower 
gives  in  exchange  for  the  credit  of  his  bank? 

In  1906  the  clearing  house  banks  of  Chicago,  for 
the  good  of  Chicago  banking,  assumed  the  liabilities 

1  Lawrence  0.  Murray,  Some  Problems  of  the  Comptroller's  Office, 
Proceedings,  Thirty  Fifth  Annual  Convention,  American  Bankers' 
Association,  1909,  p,  170. 

^  Joseph  G.  Talbert,  Proceedings,  Eighteenth  Annual  Convention, 
New  York  State  Bankers'  Association,  1911,  p.  48. 


BANK  SUPERVISION  303 

of  three  failed  banks, — the  Walsh  banks, — a  national 
bank,  a  savings  bank,  and  a  trust  company,  which  had 
been  forced  to  close  their  doors  on  account  of  misman- 
agement and  misplaced  loans.  At  this  juncture  a 
system  of  bank  examination  under  the  direct  and  close 
supervision  of  an  examiner  and  a  corps  of  assistants 
chosen  by  the  Chicago  Clearing  House  Association  was 
conceived  and,  to  the  surprise  of  its  originator,  ap- 
proved by  the  association  and  quickly  put  into  opera- 
tion. From  Chicago  the  idea  has  spread  to  Min- 
neapohs,  St.  Paul  and  a  score  of  other  leading  cities.^ 
Chicago,  as  has  been  true  of  other  cities  adopting  the 
idea,  has  followed  the  policy  of  giving  the  examiner 
a  large  measure  of  freedom  of  action,  unhampered 
by  hard  and  fast  rules  and  arbitrary  instructions. 
Whether  in  Chicago,  Los  Angeles,  Cleveland,  St. 
Louis,  or  New  York,  the  nature  of  the  examination  is 
substantially  the  same.  A  thorough  understanding  of 
the  influence  of  clearing  house  bank  examination  upon 
the  quality  of  the  basic  elements  of  security  underlying 
bank  loans  will  be  facilitated  by  a  brief  description  of 
the  method  followed  by  the  clearing  examiner  in  the 
performance  of  his  work.  The  account  that  follows, 
although  it  pertains  directly  to  the  practice  in  St. 
Louis,  may  be  regarded  as  typical. 

1  In  1916  the  banks  of  the  following  cities  were  under  supervision 
of  clearing  house  bank  examiners: — New  York,  Chicago,  Philadel- 
phia, St.  Louis,  Cleveland,  Kansas  City,  New  Orleans,  Los  Angeles, 
Milwaukee,  Louisville,  Minneapolis,  St.  Paul,  Columbus,  O., 
Nashville,  Spokane,  Portland,  Ore.,  Oklahoma  City,  Muskogee, 
Okla.,  St.  Joseph,  Mo.  Proceedings,  Forty  Second  Annual  Conven- 
tion American  Bankers'  Association,  1916,  p.  495. 


304  BANK  CREDIT 

The  System  Described 

Without  notice  and  of  his  own  volition,  the  ex- 
aminer, with  his  assistants,  enters  a  bank  or  trust 
company  and  begins  the  examination.  To  both  the 
books  and  information  of  officers  and  employees  he  has 
free  access.  Having  completed  the  examination  he 
makes  duplicate  reports,  which  contain  all  the  essen- 
tial facts  obtained  in  the  investigation.  The  amount  of 
the  cash  of  the  bank,  of  its  past  due  paper,  of  excessive 
loans,  of  its  bad  debts,  if  any,  the  amount  due  by 
the  directors  as  payers,  endorsers  or  guarantors,  the 
amount  due  by  corporations  in  which  directors  are 
interested,  the  value  and  book  valuation  of  the  bonds 
carried,  whether  or  not  capital,  surplus,  and  undivided 
profits  are  represented  by  good  assets, — these  items 
and  facts  are  set  forth  in  the  examiner's  report,  one 
copy  of  w^hich  is  delivered  by  the  examiner  to  the 
president  of  the  institution  examined.  Each  director 
of  that  institution  is  notified  by  mail  that  the  ex- 
aminer's report  is  in  the  hands  of  the  president  of  the 
institution  in  question.  A  written  request  is  made 
by  the  examiner  that  the  director  notify  the  examiner 
in  writing  of  the  receipt  of  the  notice.  If  necessary 
a  second  notice,  or  a  third,  is  sent.  The  purpose  is 
to  establish  the  fact  that  every  director  of  every  insti- 
tution which  is  a  member  of  or  connected  with  the 
St.  Louis  Clearing  House  is  informed  of  the  condition 
of  his  institution  as  disclosed  by  the  clearing  house 
bank  examiner. 

If  the  examination  reveals  nothing  indicating  bad 
management   or  unsafe   condition,   the   chairman   of 


BANK  SUPERVISION  305 

the  Committee  of  Management  of  the  clearing  house  is 
so  notified  and  the  duphcate  report  is  placed  in  the 
examiner's  files.  Under  such  condition  the  report 
is  seen  by  no  one  except  the  officers  and  directors  of 
the  examined  bank  or  trust  company. 

If  on  the  other  hand  the  examiner  finds  conditions 
different  from  the  case  just  stated,  he  submits  a  report 
to  the  Committee  of  Management.  The  committee 
then  requests  the  bank  management  to  correct  condi- 
tions under  penalty  of  having  the  institution  suspended 
from  the  clearing  house  until  a  meeting  of  the  clearing 
house  association  has  been  called  and  the  whole  matter 
placed  in  detail  before  it.  Conditions  are  almost  in- 
variably corrected  with  celerity.^ 

In  the  work  of  the  clearing  house  examiner,  in  dis- 
tinction from  that  of  state  and  national  examiners, 
chief  emphasis  is  placed  on  improving  the  quality 
of  the  bank  loans  or  of  preventing  deterioration  in  that 
quality.  Banks  in  thoroughly  sound  condition  are 
passed  quickly  by;  those  showing  signs  of  precarious 
condition  are  examined  frequently  in  order  that  they 
may  be  built  up  and  their  condition  improved.^ 

Government  authorities,  national  or  state,  may 
interfere  only  when  conditions  become  so  bad  that  the 
capital  of  the  bank  is  impaired  or  its  solvency  ques- 

'  W.  H.  Lee,  Clearing  House  Bank  Examinations,  an  address 
delivered  before  the  Missouri  Bankers'  Association,  St.  Louis, 
Mo.,  May  18,  1910,  pp.  G-8.  (Publisl)ed  by  the  St.  Louis  Clearing 
House  Association.) 

2  John  W.  Wilson,  The  Work  of  the  Clearing  House  Examiner, 
Proceedings,  Thirty  Seventh  Annual  Convention,  American  Bank- 
ers' Association,  1911,  p.  707. 


306  BANK  CREDIT 

tioned.  The  clearing  house  interferes  if  only  the 
statement  of  condition  returned  to  the  Comptroller  of 
the  Currency  or  to  the  state  banking  authorities,  as 
the  case  may  be,  does  not  show  a  true  condition  of 
existing  affairs  as  discovered  and  reported  upon  by 
the  local  examiner.^ 

Mr.  J.  B.  Forgan,  formerly  president  of  the  First 
National  Bank  of  Chicago,  and  a  close  observer  of  the 
working  of  the  clearing  house  system  of  examinations, 
says : — 

Our  methods  insure  the  stirring  up  and  elimination  of  the 
sediment  which  is  liable  to  accumulate  in  the  banks.  I  am  in 
the  habit  of  classifying  bank  assets  in  dairy  terms,  such  as 
cream,  sweet  milk,  skim  milk,  sour  milk  and  sediment.  In 
the  bank,  as  in  the  dairy,  the  sediment  falls  to  the  bottom, 
where  it  remains  out  of  sight  and  out  of  mind  unless  constant 
vigilance  is  exercised  in  its  elimination.  If  a  bank's  manage- 
ment is  weak  the  cream  is  liable  to  be  skimmed  off  the  top, 
while  the  sediment  accumulates  at  the  bottom,  and  gradually 
its  assets  become  so  permeated  with  it  that  they  form  a 
putrid  mass  of  curds  only  fit  for  the  dump  pile  of  a  receiver- 
ship. Clearing  house  examinations  tend  to  the  healthful  con- 
servation of  the  sweet  milk  and  cream  and  to  the  elimination 
of  the  sour  milk  and  sediment.^ 

Supervision  by  a  local  examiner  thoroughly  familiar 
with  the  condition  of  the  institutions  with  which  he 
has  to  do  is  highly  valuable  also  in  quite  another  re- 
spect, viz.,  in  protecting  sound  banks  against  unjusti- 

1  J.  B.  Forgan,  Clearing  House  Examinations  by  Clearing  House 
Examiners,  Proceedings,  Thirty  Sixth  Annual  Convention,  Amer- 
ican Bankers'  Association,  1910,  pp.  689,  690. 

2  Ibid.,  p.  690. 


BANK  SUPERVISION  307 

fiable  assaults,  and  delicate  credit  situations  against 
unfavorable  influences.  Mr.  Ralph  Van  Vechten,  an 
ardent  champion  of  clearing  house  bank  examination, 
illustrates  the  eflBcacy  of  the  system  in  this  connection. 

During  one  of  the  recent  stringencies  one  of  the  smaller 
banks  was  being  talked  about.  The  bank  was  perfectly 
sound.  But  this  talk  reached  a  bonding  company  which  was 
on  the  bank's  bond  for  city  deposits.  The  bonding  company 
sent  out  word  to  its  representatives  to  withdraw  from  that 
bond.  You  know  what  would  have  been  the  result  of  such  a 
withdrawal  at  such  a  time.  Mind  you,  this  was  during  a 
severe  stringency.  The  representative  of  the  bonding  com- 
pany came  to  me  and  asked  me  my  advice  about  it,  and  I 
asked  him  the  names  of  his  directors,  his  local  directors,  and 
he  submitted  them  and  I  said,  "You  go  to  this  man,"  who 
was  president  of  one  of  the  banks.  He  went  to  this  local  di- 
rector and  said,  "Will  you  recommend  that  this  bond  be 
continued?"  The  answer  was,  "I  will  recommend  that  the 
bond  be  continued  if  the  clearing  house  examiner  will  tell  me 
that  the  bank  is  sound."  He  called  up  the  examiner  over 
the  telephone  and  the  examiner  said  that  the  bank  was  abso- 
lutely sound.  The  director  immediately  telephoned  to  the 
New  York  office  of  the  company  and  the  bond  was  continued. 
Now,  things  of  that  kind  are  mentioned  as  an  illustration  of 
the  possibilities  of  the  system  and  its  benefits.  Those  things 
are  coming  up  all  the  time.^ 

The  work  of  the  clearing  house  examiner  is  comple- 
mentary to  that  of  national  and  state  examiners.  He 
is  intimately  acquainted  with  the  conditions  prevailing 
in  his  locality.    In  fact,  he  lives  in  the  locality  where 

» Ralph  Van  Vechten,  Proceedings,  Forty  First  Annual  Conven- 
tion, American  Bankers'  Association,  Seattle,  1916,  p.  501. 


308  BANK  CREDIT 

he  works.  He  knows  much  more  intimately  than  it 
is  possible  for  examiners  presiding  over  larger  territory 
to  know,  not  only  the  accounts  of  the  business  men  but 
also  their  personal  history,  methods  and  character. 

One  of  the  chief  and  distinctive  merits  of  clearing 
house  bank  super^'ision  lies  in  the  fact  that  the  exam- 
iner, unlike  the  federal  and  state  examiners,  reports 
his  findings  directly  to  the  individual  directors  who  are 
his  employers.  It  is  one  thing  to  write  a  report  to  a 
distant  federal  or  state  officer  who  does  not  know 
whether  the  report  represents  accurately  the  condition 
of  the  bank  examined;  it  is  quite  a  different  thing  to 
frame  a  report  for  the  use  of  the  officers  and  directors 
of  the  institution  itself,  who  know  more  about  its 
condition  and  intimate  affairs  than  the  examiner  can 
reasonably  hope  to  know.  His  work  must  be  so  search- 
ing and  thorough  as  to  beget  continued  confidence. 
It  is  the  opinion  of  an  examiner  with  experience  in 
both  national  and  clearing  house  ser\'ice  that  it  is  the 
necessity  of  the  detailed  report  to  the  directors  them- 
selves that  is  the  greatest  insurance  of  careful  and 
efficient  w^ork  on  the  part  of  the  examiner.^ 

Cooperation  among  clearing  house,  state,  and  na- 
tional examining  authorities  would  render  it  easy  to 
ascertain  the  amount  of  doubtful  and  worthless  loans 
and  other  assets  in  any  bank,  effectually  to  eliminate 
them,  and  prevent  their  being  shifted  from  one  insti- 
tution to  another.  There  should  be,  however,  no  ob- 
jection to  the  clearing  house  examiner  divulging  infor- 

1  Francis  Coates,  Jr.,  What  Effect  will  the  Federal  Reserve  Act  have 
on  Clearing  House  Examinations,  Proceedings,  Fortieth  Annual 
Convention,  American  Bankers'  Association,  1914,  p.  492. 


BANK  SUPERVISION  309 

mation  received  by  him  in  his  own  work  as  the  state 
and  national  examiners  have  it  within  their  power  to 
acquire  this  information  for  themselves.^ 

The  highest  degree  of  usefulness  and  success  of 
bank  examination  under  the  auspices  of  clearing  house 
associations  will  be  attained  only  through  full  coopera- 
tion with  national  and  state  systems  of  supervision, 
since  any  single  clearing  house  system  of  supervision 
cannot  safely  be  extended  beyond  limited  bounds  with- 
out a  loss  in  the  distinctive  advantages  flowing  from 
intensive  and  localized  work  and  study.  The  Los 
Angeles  system  has,  at  their  request,  been  extended  so 
as  to  include  thirty-six  banks  outside  the  city,  and 
within  this  "outer  zone"  of  twenty  miles  from  Los 
Angeles  it  would  be  difficult  for  a  bank  to  close  its 
doors.  Outlying  banks  near  Chicago  also  have  come 
under  the  supervision  of  the  clearing  house  examiner  of 
that  city.  2  Beyond  such  limits  the  system  would  likely 
lose  progressively  in  efficiency. 

Influence  upon  Loans  of  Small  Banks 

The  clearing  house  system  of  examinations  through 
provision  for  pooling  the  credit  information  of  the 
banks  of  a  given  locality  as  well  as  information  relating 
to  collateral  has  been  of  signal  value  in  raising  the 
quality  of  both   secured   and   unsecured   loans,   par- 

^  H.  M.  Zimmerman,  Cooperation  between  Clearing  House  Asso- 
ciation and  State  Banking  Department,  Proceedings,  Thirty  Seventh 
Annual  Convention,  American  Bankers'  Association,  1911,  pp.  693, 
694. 

*  Proceedings,  Forty  First  Annual  Convention,  American  Bank- 
ers' Association,  Seattle,  1915,  pp.  515,  51G. 


310  BANK  CREDIT 

ticularly  of  the  smaller  banks.  In  Los  Angeles  nine 
tenths  of  the  knowledge  obtained  regarding  collateral 
stocks  of  known  value  came  from  the  larger  banks; 
nine  tenths  of  the  stocks  of  unloiown  value  used  as 
collateral  were  found  in  the  smaller  banks. 

Some  of  the  details  of  the  way  in  which  information 
is  pooled  and  handled  may  well  be  indicated.  After 
each  examination  the  names  of  all  borrowers  of  $1,000 
and  over,  let  us  say,  are  listed  on  a  card  system.  After 
all  the  banks  have  been  examined  once,  the  cards  begin 
to  mean  something.  Some  names  may  show  heavy 
borrowings  at  several  banks.  The  card  is  before  the 
examiner  and  bears  the  name  of  the  borrowing  individ- 
ual or  concern,  the  name  of  the  lending  bank,  the 
collateral,  if  any,  the  amount  of  the  loan,  the  com- 
mercial rating,  and  the  last  financial  statement  con- 
densed. The  card  may  show  numerous  loans  at  as 
many  banks.  Each  separate  loan  is  considered;  those 
with  satisfactory  collateral  being  passed  over  quickly. 
The  unsecured  loans  are  then  decided  upon.  Let  us 
suppose  Brown  is  found  with  numerous  borrowings. 
The  card  says  he  is  worth  $200,000  and  has  borrowed 
$100,000  without  security  from  each  of  five  banks. 
Every  lending  bank  is  consulted  regarding  Brown,  his 
business,  integrity,  mode  of  life,  etc.  The  interested 
banks  are  notified  of  Brown's  borrowings,  and  asked 
if  in  their  opinion  the  credit  extended  is  warranted. 
With  the  information  in  his  possession  each  banker  is 
allowed  to  use  his  ow^n  judgment  as  to  calling  the  loan, 
demanding  security  or  allowing  it  to  stand.  The 
cards  also  contain  such  expressions  as  no  good,  liar, 
slow  pay,  moral  risk,  bad.    A  very  careful  study  and 


BANK  SUPERVISION  311 

analysis  of  the  cards  serves  to  bring  weak  borrowers  to 
the  surface.  Sometimes  the  banks  are  requested  by 
way  of  a  friendly  hint  to  have  a  given  note  secured 
by  acceptable  collateral  or  call  the  loan.  The  banks 
know  of  the  information  in  the  possession  of  the  exam- 
iner and  make  many  inquiries  concerning  the  standing 
of  firms  and  individuals  and  the  value  of  collateral. 
Inasmuch  as  the  greater  number  of  inquiries  comes 
from  the  smaller  banks  and  the  information  filed  in  the 
examiner's  office  is  free  for  the  asking,  it  becomes 
evident  at  once  that  smaU  banks  are  elevated  to  a 
position  where  they,  too,  can  learn  of  poor  risks  and 
poor  collateral  before  loans  are  made.^ 

Small  banks  before  the  installation  of  examination 
under  local  authority  providing  for  the  pooling  of 
credit  information  may  have  been  getting  a  large 
proportion  of  the  loan  rejections  of  other  and  larger 
banks  with  superior  credit  information  facilities.  To 
such  small  banks  the  establishment  of  a  system  of 
supervision  providing  for  a  free  interchange  of  credit 
information  proves  a  great  boon."^  All  banks,  whether 
large  or  small,  are  relieved  of  the  necessity  of  relying  on 
"street"  information. 

Effects  upon  Loans  to  "  Double  "  Borrowers  in  Large 
Cities 

In  our  large  cities,  particularly,  there  are  very 
many  accounts  that  are  common  to  nearly  all  the 

iJohn  W.  Wilson,  The  Work  of  the  Ckaring  House  Examiner, 
Proceedings,  Thirty  Seventh  Annual  Convention,  The  American 
Bankers'  Association,  1911,  pp.  707,  708. 

2  Ibid.,  pp.  723,  724. 


312  BANK  CREDIT 

banks  of  those  cities.  Lines  of  credit  of  a  local  nature 
but  of  vast  importance  in  the  particular  community 
are  under  no  control  except  through  the  clearing  house 
supervision  of  banks.  If  a  given  bank  desires  to  ascer- 
tain whether  a  certain  concern  is  expanding  too  fast, 
whether  it  is  using  too  much  credit,  the  clearing  house 
examiner  upon  request  gives  the  bank  total  loans  out- 
standing of  the  concern  in  question,  without,  of  course, 
disclosing  the  name  of  any  bank  involved,^  placing  the 
bank  in  a  way  to  check  or  curtail  or  cut  off  the  loans  of 
the  concern, — to  lock  the  door  before  the  horse  is 
stolen.  The  "duplicated"  borrowers'  file  built  up  by 
the  examiner  at  Cleveland,  contained  "some  thirty- 
five  hundred  names"  in  1914. ^ 

Incidental  Effects  upon  Loans 

One  of  the  most  valuable,  if  minor,  features  of  the 
system  of  examination  under  discussion  is  that  the 
detailed  report  of  the  examiner  which  is  brought  forci- 
bly to  the  attention  of  each  of  the  directors,  as  already 
explained,  causes  directors  to  know  a  great  deal  more 
about  the  affairs  of  the  bank  than  they  would  otherwise. 
Even  the  members  of  the  executive  conimittee  of  the 
bank,  who  are  very  famihar  with  its  work,  are  familiar- 
ized with  details  of  securities  or  loans  that  might  not 
come  to  their  knowledge  either  through  absence  from 
meetings  or  through  inadvertence  or  failure  of  ofiBcers 
to  make  reports.^ 

1  Ralph  Van  Vechten,  Proceedings,  Forty  First  Annual  Conven- 
tion, American  Bankers'  Association,  Seattle,  1915,  pp.  500,  501. 

2  Francis  Coates,  Jr.,  op.  cit.,  p.  490. 

'  Ralph  Van  Vechten,  op.  cit.,  p.  500. 


BANK  SUPERVISION  313 

Clearing  house  examination  has  been  at  once  a 
powerful  corrective  of  weak  loans  already  made  and  a 
positive  deterrent  to  the  further  accumulation  of  simi- 
lar paper.  The  dread  of  a  report  from  the  clearing 
house  examiner  has  been  sufficiently  strong  to  make 
banks  extremely  careful  as  to  the  bills  they  put  into 
their  portfolios.  Then  the  system  furnishes  a  very 
good  excuse  to  bankers  to  state  to  the  applicant  for 
a  loan  which  it  is  felt  preferable  not  to  grant  that  it  is 
not  the  kind  of  a  loan  which  the  clearing  house  exam- 
iner would  look  upon  with  favor.  ^ 

By  way  of  contrast  another  function  performed  by 
the  clearing  house  examiner  is  worth  noting.  In  certain 
cases  where  the  policy  of  the  institution  is  to  handle 
only  the  highest  class  of  business,  the  examiner  may 
not  think  it  amiss  to  try  to  impress  upon  the  officers 
and  directors  the  desirability  of  adopting  a  more  liberal 
poHcy  in  order  to  justify  the  existence  of  the  bank  as  a 
useful  factor  in  the  community  by  aiding  more  gener- 
ously meritorious  enterprises  that  come  naturally 
within  its  range  of  operation.^  In  other  words,  the  loan 
standards  of  the  banks  are  made  more  nearly  uniform: 
those  of  a  few  being  made  more  liberal;  of  many,  less  so. 
Clearing  house  examination  promotes  not  only  the 
soundness  of  bank  loans  but  also  the  equitable  distri- 
bution of  bank  credit  among  borrowers. 

Finally,  it  is  to  be  pointed  out  that  clearing  house 

*  Sol  Wexler,  Proceedings,  Thirty  Sixth  Annual  Convention, 
American  Bankers'  Association,  1910,  p.  665. 

*  A.  Kains,  Clearing  House  Examination  of  Banks,  Proceedings, 
Fifteenth  Convention,  California  Bankers'  Association,  1909, 
pp.  159,  160. 


314  BANK  CREDIT 

examination  of  banks  has  resulted  in  the  eUmination 
of  a  great  many  institutions  throughout  the  country 
which  did  not  deserve  to  remain  in  the  banking  busi- 
ness. It  has  also  brought  about  a  more  friendly 
feeUng  among  banks,  paving  the  way  for  consolidations, 
a  circumstance  which  has  led  to  a  much  more  conserva- 
tive and  careful  loan  policy,^  with  favorable  resulting 
effect  upon  the  quality  of  the  portfolio  contents. 

The  fact  that  the  commercial  paper  of  the  member 
banks  in  the  Federal  Reserve  system  has,  since  1914, 
been  employed  in  larger  and  larger  volmne  as  security 
underlying  the  Federal  Reserve  notes  and  deposits 
gives  added  significance  to  the  inception  and  growth  of 
clearing  house  examination  of  banks.  As  long  as  the 
Federal  Reserve  banks  continue  to  rely  chiefly  upon 
the  member  banks  to  safeguard  the  quality  of  the  paper 
which  is  rediscounted  and  subsequently  used  as  the 
basis  of  note  issues  by  the  regional  institutions  the 
examination  of  banks  under  clearing  house  auspices  will 
be  a  potent  and  salutary  force  affecting  the  elemental 
safety  of  the  only  elastic  element  in  our  monetary 
circulation.  Not  only  does  this  now  widespread  form  of 
bank  supervision  render  the  structure  of  business  and 
finance  less  liable  to  the  consuming  fires  of  crisis  and 
panic;  it  also  improves  and  intensifies  the  means 
wherewith  the  conflagration,  breaking  out,  may  be 
controlled   and   extinguished. 

The  estabhshment  of  systems  of  clearing  house 
bank  examination  by  the  leading  clearing  house  associ- 
ations in  the  United  States  during  the  decade  follow- 
ing 1906  is  a  movement  comparable  in  significance  and 
1  Sol  Wexler,  of.  ciL,  pp.  664,  665. 


BANK  SUPERVISION  315 

beneficial  results  to  the  establishment  of  credit  depart- 
ments by  our  leading  banks.  The  use  of  the  credit  de- 
partment and  the  advent  of  the  independent  examina- 
tion of  clearing  house  members  have  created  a  new  era 
marked  by  higher  standards  imposed  upon  the  sellers  of 
commercial  paper  as  well  as  the  direct  borrowers  of  banks. 

Internal  Bank  Examination 

Internal  bank  examination  may  be  by  the  board  of 
directors  of  the  bank  concerned,  or  a  committee  of  the 
board,  by  employees,  or  by  an  auditing  company  or 
chartered  accountants.  In  all  these  cases  except  the 
first,  however,  the  examination  is  likely  to  be  in  the 
nature  of  an  audit  with  little  attention  given  to  ap- 
praising the  contents  of  the  note  pouch.  Examination 
by  directors  on  the  contrary  naturally  takes  the  form 
of  evaluating  assets, — where  the  busy  directors  have 
time  and  disposition.  Directors  are  not  likely  to  be 
well  qualified  as  accountants  to  audit  the  books,  but 
they  are  commonly  able  to  pass  excellent  judgment  on 
the  paper  held  by  their  bank,  and  examinations  by 
directors  should  be  encouraged. 

When  chartered  accountants  insist  on  invoking  the 
help  of  the  directors  in  appraising  the  loans  and  other 
investments,  excellent  results  in  the  way  of  eliminating 
bad  paper  are  easily  within  reach.  Well  informed 
directors  supplement  the  work  of  chartered  account- 
ants at  its  weakest  point,  i.  e.,  the  inability  of  the 
accounting  firms  to  pass  intelligently  upon  the  names 
of  bank  borrowers. 

Probably  the  most  ambitious  attempt  of  certified 
accountants  to  overcome  the  very  patent  weakness  in 


316  BANK  CREDIT 

their  work  as  bank  examiners  is  represented  by  a  New 
York  firm,  Marwick,  Mitchell  &  Co.,  in  its  system  of 
examination  and  exchange  of  credit  information  for 
Group  1  of  the  New  Jersey  Bankers'  Association, 
consisting  of  the  banks  of  Middlesex  County,  including 
such  towns  as  New  Brunswick,  Perth  Amboy,  and 
South  River.  This  firm  of  accountants  has  itself  had 
charge  for  a  period  of  yeai's  of  securing  and  giving  out 
credit  information  which  pertains  chiefly  to  facts  ascer- 
tained from  the  banks  of  Group  1  concerning  loans 
already  extended.  A  bank  desiring  to  learn  the  loans 
of  other  banks  to  a  given  appUcant,  inquire  of  the  firm 
of  accountants,  stating  at  the  same  time  the  amount 
which  the  apphcant  owes  the  bank  in  question.  The 
accountants,  before  replying,  revise  their  files  touching 
the  borrower  concerned  by  direct  inquiry  to  all  the 
banks  in  the  group. 

The  plan  also  makes  provision  for  a  thorough 
examination  by  the  accountants  of  the  banks  within 
the  group.  During  the  course  of  the  examination  the 
examiner  meets  with  the  board  of  directors  or  a  com- 
mittee of  the  same  and  together  they  go  over  the  loans. 
Upon  completion  of  the  examination  a  full  report  is 
prepared  by  the  examiner  and  dehvered  to  the  presi- 
dent of  the  bank.  Space  is  pro\dded  upon  which  the 
directors  are  to  sign  their  names  after  reading  the 
report,  which  may  include,  if  occasion  require,  brief 
recommendations  concerning  improvements  in  the 
system  and  records  of  the  bank.^ 

^  Andrew  A,  Benton,  A^ew  Jersey  System  of  Group  Bank  Examina- 
tionSy  Proceedings,  Eighth  Annual  Convention,  New  Jersey  Bank- 
ers' Association,  1911,  pp.  48,  49. 


BANK  SUPERVISION  317 

It  is  a  merit  of  the  New  Jersey  plan  that  its  adoption 
is  an  encouragement  to  borrowers  to  employ  chartered 
accountants  to  certify  to  the  statements  submitted  to 
bankers  when  application  for  accommodation  is  made. 

According  to  an  officer  of  one  of  the  leading  banks 
concerned,  this  system  has  been  very  satisfactory  and 
the  credit  bureau  very  beneficial. 

Of  the  various  forms  of  internal  examination  of 
banks  the  futm-e  will  probably  witness  the  most  marked 
development  and  spread  of  examination  by  directors. 
It  is  clearly  recognized  that  the  character  of  the  loans 
and  discounts  is  the  crux  and  core  of  safe  and  profi- 
table banking,  and  state  legislators,  particularly,  are 
becoming  conscious  of  the  protective  and  purging 
value  of  examinations  made  by  a  bank's  own  directors. 

The  Michigan  banking  law  makes  ''it  mandatory 
upon  the  directors  of  each  State  bank  to  appoint  an 
examining  committee  from  among  their  number,  or 
from  among  the  stockholders,  to  examine,  every  six 
months,  the  affairs  of  their  respective  banks,  requiring 
the  report  of  such  examination  to  be  spread  upon  the 
directors'  records  and  forwarded  to  the  Commissioner 
of  the  Banking  Department.  Anything  tending  to 
require  greater  diligence  on  the  part  of  the  directors  in 
the  management  of  the  banks  under  their  control  works 
for  the  betterment  of  the  bank,  making  violations  of 
the  statutes  less  Ukely.  Such  examinations  are  a  guar- 
antee to  the  Department  that  the  assets  examined  and 
verified  by  its  examiners,  are  bona  fide,  and  that  their 
character  is  thoroughly  understood  by  the  directors. 
This,  in  a  large  measure,  corrects  the  difficulty  hereto- 
fore experienced  by  the  Department,  in  this,  that  the 


318  BANK  CREDIT 

examiner  being  unacquainted  with  local  credit  lines 
and  securities  was  unable  to  ascertain  and  report  the 
value  of  many  of  the  assets  of  the  bank  examined."^ 

Our  bank  directors  have  it  within  their  power  greatly 
to  improve  the  quality  of  American  bank  loans  and 
investments. 

Conclusion 

Numerous  as  are  the  forms  of  examination,  varied 
as  are  the  jurisdictions,  there  is  still  an  inadequacy 
of  supervision,  but  an  inadequacy  of  quality  rather 
than  quantity.  Not  until  the  national  and  state  super- 
vising agencies,  cooperating  with  each  other  and  with 
clearing  house  examiners,  are  able  to  cope  on  a  large 
scale  with  excessive  and  multiple  borrowing  as  effec- 
tively as  have  the  clearing  house  examiners  in  our 
leading  cities  already  done,  can  it  be  maintained  that 
further  reform  and  progress  are  not  greatly  to  be 
desired.  The  extension  of  the  work  of  the  credit  bureau 
as  already  well  begun  by  states  like  New  York  and 
Indiana,  the  placing  of  the  compensation  of  examiners 
on  a  salary  basis,  as  has  been  done  by  Pennsylvania, 
Minnesota  and  the  federal  government,  the  elimination 
of  politics  from  appointments,  more  frequent  and  ac- 
tive participation  of  directors  in  examinations  under 
whatever  auspices, — these  are  the  things  needed. 

1  Report  of  the  Commissioner  of  Banking  for  the  State  of  Mich- 
igan, 1907,  p.  xviii. 


APPENDIX  A 

QUESTION,  EXERCISES,  AND  PROBLEMS 

CHAPTER  I 

1.  Define  bank  credit. 

2.  In  what  sense  is  a  bank  acceptance  bank  credit?  In 
what  not? 

3.  What  circumstances,  if  any,  justify  the  appUcation 
of  the  term  bank  credit  to  deposits? 

4.  Indicate  points  of  similarity  and  of  difference  between 
bank  credit  and  commercial  credit. 

5.  What  is  the  legitimate  scope  of  bank  credit  extension? 

6.  Compare  or  contrast  the  banking  danger  involved 
in  investments  in  bonds  and  that  involved  in  investments 
in  frequently  turned  promissory  notes. 

7.  Explain  the  increasing  tendency  of  borrowers  to  rely 
on  continuous  bank  loans. 

8.  Is  continuously  floating  paper  marketed  by  note 
brokers  liquid? 

9.  What  would  failure  on  the  part  of  a  bank  customer 
to  reduce  his  loans  to  a  low  ebb  at  least  once  a  year  indicate 
with  reference  to  permanent  capital  in  the  business? 

10.  Under  what  conditions  are  commercial  banks  justified 
in  lendmg  heavily  to  non-seasonal  borrowers,  e.  g.,  tanners? 

CHAPTER  II 

1.  What  is  a  balance  sheet  or  financial  statement  of  a  bank? 

2.  Why  is  capital  a  liability? 

3.  Contrast  the  financial  plan  of  a  representative  bank 
with  that  of  a  representative  non-banking  business  corpora- 
tion.    Account  for  the  difference.     (By  financial  plan  is 

319 


320  APPENDIX  A 

meant  the  way  in  which  capital  is  raised,  whether  by  bonds, 
preferred  stock,  common  stock,  etc.)  Would  the  business  of 
receiving  deposits  argue  against  the  issue  of  bonds  by  a 
bank?    Why? 

4.  Why  does  the  Fletcher  American  National  Bank  of 
Indianapolis  keep  balances  on  deposit  with  New  York, 
Chicago  and  other  banks? 

5.  Is  "exchange"  an  asset  or  liability?  An  overdraft? 
Why? 

6.  What  forces  restrain  the  banker  in  executing  a  liberal 
loan  policy? 

7.  Ought  a  reserve  be  required  against  United  States 
deposits?  Against  amounts  due  to  other  banks?  Cashier's 
checks?    Why? 

8.  Define  bank  surplus.  How  does  it  differ  from  capital? 
From  undivided  profits?    Is  surplus  ever  cash? 

9.  An  applicant  for  credit  at  a  bank  was  told  by  the 
cashier  that  the  bank  might  lend  him  a  part  of  its  surplus. 
Criticise  the  cashier's  statement. 

10.  If  you  were  given  a  free  hand  in  the  examination  of 
the  affairs  of  a  bank,  how  would  you  proceed  to  ascertain  the 
amount  of  (a)  capital,  (b)  surplus,  and  (c)  undivided  profits? 

11.  National  and  state  banks  and  trust  companies  be- 
coming members  of  the  Federal  Reserve  system  are  re- 
quired to  purchase  Federal  Reserve  bank  stock  equal  to  3 
per  cent  of  their  combined  capital  and  surplus  and  to  sub- 
scribe for  an  equal  amount  additionally.  Are  there  any  other 
items  in  the  balance  sheet  as  fixed  in  amount  as  capital  and 
surplus? 

12.  A  bank  has  a  capital  of  $100,000,  surplus  and  profits 
of  $74,124.38.  Its  paid  up  stock  in  the  Federal  Reserve 
Bank  of  Chicago  is  $4,500.  What  is  the  amount  of  the 
surplus? 

13.  What  is  double  liability?    Illustrate. 

14.  Which   of   the   national    bank   balance   sheets   here 


APPENDIX  A  321 

given  represents  the  greater  protection  afforded  depositors, 
assuming,  of  course,  that  the  book  values  represent  the  ac- 
tual values  and  that  the  shareholders  are  fully  responsible 
for  the  double  liability  attaching  to  their  stock? 

No.  1 

Loans  and  Discounts. $1,000,000    Capital $     25,000 

Other  Assets 200,000    Surplus 150,000 

Cash 100,000    Undivided  Profits ....        25,000 

Notes,  etc 100,000 

Deposits 1,000,000 


$1,300,000  $1,300,000 

No.  2 

Loans  and  Discounts .  $1,000,000    Capital $    100,000 

Other  Assets 100,000    Surplus 20,000 

Cash 100,000    Undivided  Profits ....  5,000 

Deposits 1,000,000 

Notes 75,000 


$1,200,000  $1,200,000 

15.  What  is  reserve  liability?  Why  was  the  principle 
introduced?  Is  it  superior  to  double  liability  from  the 
standpoint  of  the  shareholder?  From  the  standpoint  of  the 
public? 

16.  The  National  Bank  Act  limits  the  loans  of  a  national 
bank  to  10  per  cent  of  its  combined  capital  and  surplus 
(and  to  30  per  cent  of  its  capital)  to  an  individual,  firm  or 
corporation.  A  certain  national  bank  having  capital  of 
$50,000,  surplus  of  $75,000  and  undivided  profits  of  $10-, 
685.20  desires  to  reduce  the  legal  limit  above  referred  to  as  a 
means  of  finding  a  pretext  for  holding  certain  "sick"  bor- 
rowers in  check.  How  can  the  limit  be  reduced  through  a 
bookkeeping   operation? 


322  APPENDIX  A 

17.  What  are  concealed  assets? 

18.  Cite  methods  of  concealing  assets. 

19.  Why  are  assets  ever  concealed?  Why  are  liabilities 
concealed?  Why  are  assets  more  likely  to  be  concealed  in 
banking  than  in  non-banking  business  enterprises? 

20.  Items  relating  to  the  banks  of  Greenville,  S.  C,  at  the 
close  of  business  September  12,  1919. 

Surplus  and  Year  Market 

Name  of  Bank                     Capital       Undivided  Deposits  Organ-  Value  of 

Profits  ized  Stock 

American  Bank S  75,000      $256,203  $    866,823  1890  150 

Bank  of  Commerce 100,000          43,000  1.026,232  1906  135 

Farmers  &  Merchants  Bank 50,000          26,669  943,459  1907  145 

First  National  Bank 100,000        148,997  2,121,260  1872  270 

Norwood  National  Bank 250,000        358,967  3,657,684  1907  275 

Peoples  National  Bank 200,000        209,799  2,112,394  1887  200 

Assume  capital,  surplus  and  undivided  profits  to  be  accu- 
rate criteria  of  bank  stock  values  and  calculate  which  stock 
in  the  list  given  would  represent  the  greatest  investment 
worth  at  the  price  quoted.  Which  would  be  second  choice? 
Third,  fourth,  fifth,  sixth? 

21.  The  Hanover  National  Bank  of  New  York  has  a 
capital  of  $3,000,000  and  combined  surplus  and  undivided 
profits  of  $18,000,000.  If  it  pays  dividends  at  the  rate  of 
32  per  cent  per  annum,  at  what  price,  roughly,  ought  the 
shares  to  sell  in  the  market? 

22.  (a)  A  bank  having  a  capital  of  $150,000  declares 
a  six  per  cent  semi-annual  dividend.  Title  to  100  shares 
is  the  subject  of  litigation  and  the  dividend  thereon  is  un- 
paid. The  remaining  dividends  are  paid  by  cashier's  checks. 
State  the  effect  of  the  dividend  payment  on  the  balance 
sheet. 

(b)  Ought  a  bank  to  be  required  to  hold  a  reserve  against 
all  dividend  checks  outstanding?    Why? 

23.  A  bank  having  total  resources  of  $975,000  is  am- 
bitious to  overtop  the  million  mark.  How  would  its  total 
resources  and  liabilities  be  affected  if  it  borrowed  $25,000 


APPENDIX  A 


323 


from  a  correspondent  bank  and  then  made  an  addition  to 
its  loans  of  $30,000,  two  thirds  of  the  proceeds  being  drawn 
against  by  check  and  surrendered  through  the  clearing  house 
to  other  banks? 

24.  Which  balance  sheet  subjoined  indicates  the  more 
hquid  banking  condition? 


No.  1 

Unsecured  Loans $   400,000    Capital 

(Average  time  90  days) 

Real  Estate  Loans. . . .      400,000 

Bonds    of    Foreign 

Governments 

Union    Pacific    Rail- 
way Bonds 50,000 

Real  Estate 50,000 

Cash 50,000 


$  75,000 

Surplus 175,000 

Undivided  Profits 50,000 

50,000    Deposits 700,000 


$1,000,000 


$1,000,000 


Unsecured  Loans ....  3 
(Average  time  90  days) 

Railway  Bonds 50,000 

Real  Estate 50,000 

Cash 100,000 


No.  2 
800,000    Capital. 


Surplus 

Undivided  Profits . . . 

Deposits 900,000 


50,000 
25,000 
25,000 


$1,000,000  $1,000,000 

25.  Arrange  the  following  items  as  a  balance  sheet: 


Banking  House $  20,000 

United  States  Bonds. .  .  40,000 

Due  to  Banks 23,626 

Circulating  Notes 40,000 

Cash 17,818 

Due  from  Banks 32,188 

Time  Deposits 217,932 


Other  Assets $  14,318 

Loans  and  Discounts. .  285,408 

Demand  Deposits 56,660 

Undivided  Profits 1,514 

Surplus 20,000 

Capital 50,000 


324  APPENDIX  A 

Draw  up  a  new  balance  sheet  after  the  following  trans- 
actions have  been  completed: 

a.  Lend  $2,000  for  6  months  at  6%,  one  fourth  in  cash  and 
three  fourths  in  deposits. 

b.  Sell  $2,000  worth  of  other  assets  for  $2,500. 

c.  Pay  dividend  of  4%,  one  half  the  amount  being  left 
on  deposit;  one  half  in  cash. 

d.  Assume  a  customer  having  a  balance  of  $300  remits 
check  for  $310  to  Cleveland,  whence,  after  passing  through 
a  correspondent  bank  there,  it  is  returned  to  this  bank  and 
honored, 

e.  Buy  a  new  vault  for  $3,000,  giving  in  payment  a  New 
York  draft. 

/.  Receive  deposits  of  $10,000;  $4,000  in  greenbacks  and 
gold  and  silver  certificates,  $1,000  in  notes  of  this  bank, 
$3,000  in  checks  on  other  banks,  and  $2,000  in  checks  on  this 
bank. 

g.  Pay  by  cashier's  check  a  claim  for  damages  of  $225. 

h.  Sell  at  a  discount  of  3  per  cent  $2,500  of  six  months 
paper,  bought  from  a  note  broker  and  having  three  months 
to  run,  and  leave  the  proceeds  on  deposit  with  a  correspond- 
ent bank. 

i.  Rediscount  $5,000  eligible  paper  at  Federal  Reserve 
Bank,  taking  one  fifth  in  Federal  Reserve  notes  and  four 
fifths  as  deposit  credit. 

26.       Resources  Liabilities 

Loans $  800,000  Capital $  50,000 

Securities 50,000  Surplus 50,000 

Real  Estate 20,000  Undivided  Profits 20,000 

Due  from  Banks 30,000  Due  to  Banks,  etc 80,000 

Reserve 100,000  Deposits 800,000 


$1,000,000  $1,000,000 


APPENDIX  A  325 

(a)  What  would  be  the  effect  on  the  balance  sheet  given 
above  if  the  bank  to  which  it  pertains,  introducing  more 
detailed  and  more  exact  accounting  methods,  discovered 
that  the  balance  sheet  was  correct  except  that  discount 
collected  but  unearned  amounted  to  S2,000  and  that  interest 
earned  but  not  collected  amounted  to  $1,000? 

(6)  Why  is  interest  earned  but  not  collected  an  asset? 
Why  and  to  whom  is  discount  collected  but  unearned  a  lia- 
bility? 

(c)  Would  the  discovery  of  an  excess  of  discount  collected 
but  unearned  over  interest  earned  but  not  collected  have  the 
same  effect  on  the  item  of  undivided  profits  as  would  an  ac- 
tual loss  of  equal  amount?  Would  such  a  discovery  have 
the  same  effect  on  the  economic  interests  of  the  shareholders 
as  would  an  actual  loss?    Why? 

(d)  This  bank  institutes  the  practice  of  making  an  account- 
ing allowance  for  taxes  accrued,  which  amount  to  $138.00. 
Indicate  the  changes  involved  in  the  balance  sheet. 

CHAPTER  III 

1.  Would  the  deposit  of  checks  on  other  banks  be  as  ac- 
ceptable to  you,  if  a  banker,  as  would  the  deposit  of  actual 
cash?    Why? 

2.  What  is  the  "riddle"  of  banking? 

3.  Explain  the  manufacture  of  bank  credit  as  described 
by  Horace  White  and  others. 

4.  Why  would  the  acquisition  of  a  "cash"  deposit  of  a 
million  dollars  by  the  Liberty  National  Bank  of  New  York 
be  an  insufficient  basis  for  a  loan  and  deposit  expansion  of 
several  times  the  amount? 

5.  Develop  the  formulas  X  =  — ■  and  D  =  — 

R  R. 

6.  Distinguish  between  primary  and  derivative  deposits. 

7.  A  Vermont  banker  says,  "We  have  a  customer  who 


326  APPENDIX  A 

keeps  an  average  balance  of  $5,000,  and  makes  deposits  and 
checks  out  each  day.  He  comes  in  and  hires  $2,000  because 
of  a  shipment  of  goods  totahng  this  amount  and  pays  in- 
voice. As  far  as  we  know  he  used  this  $2,000,  but  he  may 
have  paid  from  the  $5,000,  leaving  his  promissory  note  to 
keep  up  the  average  balance. "  Would  this  kind  of  operation 
fly  in  the  face  of  our  conception  of  derivative  deposits? 
Why  not? 

8.  Why  does  the  ratio  of  derivative  deposits  to  loans 
vary  more  widely  from  borrower  to  borrower  than  from  bank 
to  bank? 

9.  Enumerate  the  principal  factors  afifecting  the  deriva- 
tive deposit-loan  ratio. 

10.  Why,  in  general,  is  the  derivative  deposit-loan  ratio 
higher  in  the  case  of  city  banks  than  in  country  banks? 

11.  Draw  asymmetrical  derivative  deposit  curves  repre- 
senting loans  of  varying  maturities  to  show  that  the  volume 
of  derivative  deposits  for  a  given  bank  tends  to  remain  con- 
stant over  a  period  of  time. 

12.  "Some  concerns,"  says  a  Chicago  banker,  "borrow 
very  heavily  for  a  short  period  of  the  year,  say  from  four  to 
not  over  seven  months,  during  which  time  they  not  only  use 
these  loans,  but  every  penny  of  available  balance.  On  the 
other  hand,  during  from  five  to  eight  months  of  the  year  they 
carry  large  balances  and  do  not  borrow.  Such  accounts  will 
invariably  show  better  than  a  20%  average  balance  against 
the  average  loan  if  taken  over  a  period  of  twelve  months,  yet 
during  the  Ufe  of  the  loan  the  balance  is  nil." 

Would  it  be  legitimate  to  saj^,  from  the  standpoint  of 
one  who  is  attempting  to  give  an  exposition  of  banking 
theory,  that  the  derivative  deposits  in  this  case  are  simply 
zero  and  that,  if  all  the  bank's  customers  were  of  this  type, 
the  aggregate  volume  of  primary  deposits  of  the  bank  would 
tend  to  be  uniform? 

13.  Some  concerns  customarily  borrow  "practically  their 


APPENDIX  A  327 

own  money;  in  other  words,  their  balances  would  equal  or 
perhaps  exceed  the  amount  they  are  borrowing,  but  they 
need  such  balances,  ..." 

What  is  the  derivative  deposit-loan  ratio  maintained  by 
such  borrowers? 

14.  "A  given  concern  feels  that  they  need  a  balance  of 
say  $25,000.00  to  care  for  the  ordinary  turnover  of  their 
business.  They  will  keep  that  balance  when  they  are  not 
borrowing,  and  when  the  exigencies  of  their  industry  tend 
to  deplete  the  balance  they  will  borrow  from  time  to  time 
in  order  to  maintain  it  constantly  at  approximately  the 
predetermined    figure." 

What  would  the  derivative  deposit-loan  ratio  be  in  this 
case? 

15.  "Theoretically,"  says  a  California  banker,  "your 
diagram  (Number  1)  contains  all  the  desirable  points,  but 
in  practice  you  will  find  that  it  does  not  work  out,  for  gener- 
ally when  a  man  borrows  money  he  has  incurred  the  indebt- 
edness pre\aously  and  to  save  interest  would  put  off  pay- 
ment as  long  as  possible,  and  then  probably  pay  it  out 
all  in  one  sum.  .  .  .  Further,  when  a  man  borrows  money, 
especially  a  business  man,  he  anticipates  the  probable  date 
when  he  will  collect  certain  sums  and  so  times  his  loan  to 
take  care  of  the  period  only;  so  he  does  not  in  practice,  pile 
up  money  in  anticipation  of  pajdng  the  loan." 

If  the  synchronism,  or  concurrence  of  events,  here  in- 
volved was  imperfect  or  incomplete,  would  derivative  de- 
posits emerge? 

May  we  not  truly  say  that  complete  or  perfect  synchron- 
ism would  exist  only  theoretically,  using  "theoretically"  in 
the  sense  in  which  the  California  banker  uses  it? 

16.  Why  is  ci,  in  connection  with  the  formula  for  the 
determination  of  individual  bank  loan  expansion  trace- 
able to  additional  primary  deposits,  equal  to  (1  — k)x? 
Why  is  ci  also  equal  to  c— re— krx? 


328  APPENDIX  A 

c(l  -r) 

17.  Memorize  the  formula  x  =  — ^^ — 

kr+l-k 

18.  A  New  York  bank  whose  borrowing  customers  on  the 
average  leave  15  per  cent  of  their  loans  on  deposit  has  a 
reserve-deposit  ratio  of  13  per  cent.  How  great  an  addition 
to  its  loans  can  be  made  as  a  result  of  the  acquisition  of  new 
deposit  accounts  of  $500,000? 

19.  Under  what  conditions  will  the  loan  expansion  ren- 
dered practicable  by  a  primary  deposit  acquisition  be  equal 
to  that  acquisition? 

c(l— r) 

20.  What  qualification  of  the  formula,  x  =  ; — ; -» 

kr+1— k 

is  called  for  in  connection  with  banks  in  one-bank  towns? 
What  circumstances  minimize  the  importance  of  this  quali- 
fication? 

21.  As  a  result  of  amalgamations  London  Clearing 
House  banks  have  been  reduced  in  recent  years  from  almost 
a  score  to  seven.  Have  the  consolidations  increased  the 
amount  that  any  one  of  the  banks  can  safely  lend  as  a  result 
of  acquiring  additional  deposit  accounts? 

Does  bank  amalgamation,  by  increasing  size  of  bank, 
render  a  reduction  in  the  reserve-deposits  ratio  possible 
without  impairing  the  power  to  meet  deposit  liabilities  on 
demand?  If  a  bank  had  only  one  depositing  customer,  how 
large  a  reserve  would  be  needed? 

If  bank  amalgamation  in  England  should  continue  until 
two  banks  of  equal  banking  power  had  all  deposit  and  loan 
accounts,  how  would  that  fact  be  reflected  in  the  overflow 
cash  of  either  bank? 

22.  If  the  nineteen  chartered  banks  of  Canada  became 
completely  merged,  it  would  be  as  if  the  derivative  deposit- 
loan  ratio  of  the  amalgamated  institution  were  100  per  cent. 
Explain. 

Substitute  100  per  cent  for  k  in  the  formula  for  determin- 


APPENDIX  A  329 

ing  individual  bank  loan  expansion  on  the  basis  of  cash  ac- 
quired through  deposit  and  calculate  the  loan  expansion  of 
such  a  bank  as  mentioned  above,  using  $1.00  for  c  and  10 
per  cent  for  r. 

23.  A  typical  American  bank  can  ordinarily  increase 
its  loans  by  an  amount  approximately  equal  to  an  addition 
to  its  primary  deposits  on  the  basis  of  a  new  cash  acquisi- 
tion, but  our  banks  taken  in  the  aggregate,  and  without 
assistance  from  bankers'  banks,  would  be  able  to  increase 
their  loans  by  approximately  nine  times  the  newly  acquired 
cash.    Explain  and  illustrate  by  diagram. 

24.  Illustrate  diagramatically  the  way  in  which  new  cash 
becomes  distributed  as  the  basis  of  manifold  loans  and  de- 
posits in  the  banking  system,  assuming  a  reserve-deposits 
ratio  of  20  per  cent  and  a  derivative  deposit-loan  ratio  of  25 
per  cent. 

25.  The  multiplicative  importance  of  reserves  in  relation 
to  loans  and  to  deposits  in  the  banking  system  is  not  trace- 
able to  the  fact  that  borrowers  withdraw  less  than  100  per 
cent  of  the  proceeds  of  their  loans.  Substitute  zero  for  k, 
one  dollar  for  c,  and  50  per  cent  for  r  in  the  formula  for 
determining  the  individual  bank  loan  expansion  on  the 
basis  of  a  deposited  cash  acquisition,  and  in  accordance 
with  your  results  draw  a  diagram,  modeled  after  number  3, 
showing  the  way  in  which  new  cash,  under  homogenous 
conditions  throughout  the  banking  system,  would  be  dis- 
tributed and  become  the  foundation  of  manifold  loans  and 
deposits. 

26.  Are  the  deposits  of  a  bank  the  offspring  of  its  loans  or 
are  its  loans  the  offspring  of  its  deposits,  i.  e.,  cash  or  its 
equivalent  deposited? 

Consider  the  same  question  in  relation  to  the  banking 
system. 

27.  A  country  bank,  bank  A,  has  $10,000  in  cash  and 
$100,000  in  each  deposits  and  loans.    A  neighboring  bank, 


330  APPENDIX  A 

B,  has  $20,000  in  cash  and  $200,000  in  each  deposits  and 
loans.  A  depositor  withdraws  $10,000  in  gold  from  bank  B 
and  lodges  it  with  bank  A.  Would  the  cash  of  bank  A  now 
constitute  potential  support  for  $200,000  each  of  loans  and 
deposits?     Why  not? 

28.  Would  the  purchase  by  a  bank  of  newly  issued  bonds 
tend  to  swell  the  deposits  of  (a)  that  bank  and  (b)  the  bank- 
ing system  as  would  the  extension  of  credits  to  customers? 
Explain. 

29.  Do  deposits  and  loans  tend  to  be  equal  in  an  individ- 
ual bank  because  loans  arise  out  of  deposited  cash  or  its 
equivalent? 

30.  Why  are  deposits  and  loans  in  the  banking  system 
approximately  equal? 

Would  a  doubling  of  our  bank  capital  in  United  States, 
with  reserves  assumed  to  remain  fixed  in  amount  and  in 
percentage,  tend  to  affect  the  volume  of  loans  but  not  that  of 
deposits?    Explain. 

31.  Explain  the  way  in  which  the  withdrawal  of  cash 
from  an  individual  bank  effects  a  widespread  contraction 
of  loans  and  deposits. 

32.  Refute  the  contention  that  banks  can  afford  to 
maintain  expensive  establishments,  to  supply  stationery 
and  render  other  services  because  they  can  lend  ten  dollars 
as  a  result  of  receiving  one  on  deposit? 

33.  Describe  the  way  in  which  an  individual  bank  with 
relatively  heavy  deposits,  large  surplus  reserves  and  small 
volume  of  loans  becomes  assimilated  to  the  system. 

34.  Develop  the  formula  x  = •    Would  a  given 

kr+l-k 

bank  be  able  to  lend  more  or  less  than  the  application  of 
the  formula  would  indicate  if  other  banks  in  the  system 
were  expanding  their  loans,  either  as  a  result  of  additions  to 
their  reserves  or  as   a   result  of  a   reduction   in   the   re- 


APPENDIX  A  331 

serve-deposits  ratio?     If  other  banks  were  contracting  their 
loans?    Explain. 

35.  Assets  Liabilities 

Loans  and  Discounts, .  .$200,000  Capital $  50,000 

Bonds 50,000  Surplus 50,000 

Banking  House 25,000  Undivided  Profits 25,000 

Other  Assets 25,000  Deposits 210,000 

Cash 210,000  Other  Liabilities 175,000 


$510,000  $510,000 

The  bank  whose  balance  sheet  is  given  above  normally 
maintains  a  reserve-deposits  ratio  of  10  per  cent  and  its 
customers  on  the  average  leave  10  per  cent  of  their  loans 
on  deposit.  What  is  the  amount  of  its  surplus  reserve? 
How  much  can  it  increase  its  loans  without  impairing  its 
normal  reserve-deposits  ratio? 

Draw  up  the  balance  sheet  after  the  loans  have  been 
made  and  the  proceeds  drawn  upon. 

c  \  1  ~  r)  c 

36.  Apply  both  formulas,  x  =  — ^^ ->  and  x  = > 

kr+l-k  kr+l-k 

in  problem  35  and  observe  that  the  results  are  identical. 

37.  What  is  the  three-fold  process  by  which  a  normal 
ratio  of  reserves  to  deposits  is  reached  in  an  individual  bank? 
The  two-fold  process,  in  the  banking  system? 

CHAPTER  IV 

1.  Explain  carefully  why  a  given  bank  tends  to  retain 
its  cash  despite  liberal  lending,  if  all  other  banks  are  follow- 
ing an  equally  liberal  lending  policy. 

Substantially  the  same  result  would  ensue  if  some  banks 


332  APPENDIX  A 

in  the  system  were  investing  in  new  banking  houses  or  long 
term  bonds,  instead  of  increasing  their  loans.    Why? 

2.  The  banker  regulates  his  cash-deposits  ratio  through 
his  control  over  cash.  If  his  cash-deposits  ratio  fell  below 
the  limits  of  law  or  prudence,  would  it  be  practicable  to  in- 
crease it  by  securing  new  primary  deposits?  By  new  deriva- 
tive deposits? 

3.  Reserve  and  deposits  in  an  individual  bank  are  mutu- 
ally detenninative.    Explain. 

4.  What  force  or  forces  impel  the  banker  to  contract  his 
loans  when  cash  runs  low?    What  when  cash  is  plethoric? 

5.  If,  in  the  banking  system  as  a  whole,  loans  and  de- 
posits are  a  function  of  cash,  why  are  the  loans  and  deposits 
of  an  individual  bank  not  a  function  of  cash? 

6.  Comment  upon  whatever  mutual  determinism  may  ex- 
ist between  cash  and  deposits  (and  therefore  loans)  in  the 
banking  system  regarded  as  an  aggregate. 

CHAPTER  V 

1.  Why  would  the  accumulation  of  bank  surplus,  if  that 
surplus  were  always  matched  by  cash,  result  in  weakening 
the  protection  of  depositors  in  our  national  banks? 

2.  A  new  bank  has  reserves  equal  to  its  loans  and  to  its 
deposits,  and  surplus  reserves  equal  to  its  surplus.  If  it  is 
brought,  through  an  extension  of  its  loans,  into  harmony 
with  the  system  as  to  the  reserve-deposits  ratio,  would  the 
new  loans  be  several  times  the  reserve  or  would  the  reserve 
become  only  a  fraction  of  the  new  loans?  What  would  be 
the  relation  of  the  surplus  reserve  to  surplus  after  the  new 
loans  were  made  and  the  deposited  proceeds  drawn  upon  by 
check? 

3.  Why  does  surplus  represented  by  cash  in  an  individual 
but  not  isolated  bank  cease  to  be  represented  by  cash  when 
loan  expansion  founded  on  that  cash  occurs? 


APPENDIX  A 


333 


4.  Show,  by  reference  to  a  consolidated  balance  sheet, 
what  takes  place  within  a  banking  system  when  surplus 
is  accumulated  in  relation  to  cash  and  creditor  liabili- 
ties. 

5.  State  and  explain  the  causal  relation  between  cash  and 
deposits  and  between  deposits  and  surplus. 

6.  Enumerate  (a)  factors  or  forces  that  admit  of  a  reduc- 
tion in  ratio  of  cash  to  deposits  without  impairing  the  im- 
mediate convertibility  of  deposits  and  (b)  factors  that  make 
for  a  lower  ratio  of  surplus  to  creditor  liabilities  without 
reducing  the  chances  of  the  ultimate  payment  of  those 
liabilities. 

7.  In  what  sense  is  bank  reserve  "barren"  ? 

8.  What  are  the  facts  in  regard  to  the  proportion  of  loss  to 
the  total  deposits  in  national  banks,  1881-1919? 

9.  Comment  upon  the  relation  of  the  protective  items  to 
deposits  in  our  national  banks  January,  1914,  and  June, 
1919,  as  shown  in  the  subjoined  table. 


Capital  Surplus  and 
Undivided  Profits 

Deposits 

January,  1914 

$2,049,783,151 

$  8,393,372,772 

June,  1919 

2,363,478,000 

15,924,865,000 

10.  The  dependence  of  immediate  convertibility  of 
depositors'  claims  upon  a  cash  reserve  is  of  a  different  order 
from  the  dependence  of  the  ultimate  convertibility  of  cred- 
itors' claims  upon  surplus  and  other  protective  magnitudes. 
Explain. 

11.  Compare  the  first  Bank  of  the  United  States,  1811, 
and  the  second  Bank  of  the  United  States,  1829,  as  to  (a) 
immediate  convertibility  of  notes  and  deposits  and  (b) 
ultimate  convertibility  of  creditor  liabilities,  as  below. 


334 


APPENDIX  A 


First  Bank  of  the  United  States 
(Incorporated  by  Congress  in  1791  for  20  years) 

(In  millions  of  dollars) 
Resources  January,  1811  Liabilities 


Loans  and  discounts $14 . 6 

U.  S.  6  per  cent  and  other 
United  States  stock ....     2.8 

Due  from  other  banks 9 

Real  estate 5 

Notes  of  other  banks 4 

Specie 5.0 


$24.2 


Capital $10.0 

Surplus 5 

Circulation 5.0 

Individual  deposits 5.9 

United  States  deposits. ...     1.9 

Due  to  other  banks 6 

Unpaid  drafts  outstanding.       .2 


t.2 


Second  Bank  of  the  United  States 
(Chartered  by  Congress  in  1816,  for  20  years;  renewal  of  charter 
denied;  reorganized  as  a  Pennsylvania  corporation.  The  bank  as- 
signed in  1841,  final  liquidation  taking  place  in  1856,  when  deposi- 
tors and  note  holders  were  paid  in  full,  interest  and  principal;  the 
shareholders,  however,  receiving  nothing  on  their  investment.) 


(In  millions  of  dollars) 


Resources 

1825     1829 
Loans  and  Discounts.  ..$31.8  $39 . 2 


Stocks 18 

Real  Estate 1 


Banking  house. 
Due  from  foreign  bank- 
ers   

Due  from  state  banks. . 
Notes  of  state  banks. .  . 
Specie 


1.9 


2.1 
1.1 
6.7 


16.1 
2.3 
1.6 

.5 
1.7 
1.3 
6.1 


18S2 
$66.3 


2.1 
1.2 

.1 
3.9 
2.2 

7.0 


Liabilities 

1825 


1829     18SZ 


21.4 
22.8 


Capital $35 .0  $35 . 0  $35 . 0 

Circulation 6.1  11.9     21.4 

Deposits 12.0  17.1 

Due  to  foreign  banks, 

etc 2.4  1.4 

Due  to  state  banks.  . 

Other  liabilities 8.0  3.4 


2.0 
1.6 


$63.5  $68.8  $82.8 


$63.5  $68.8  $82.8 


What  was  the  comparative  condition  of  the  second  Bank 
of  the  United  States  as  to  (a)  immediate  convertibility  of 
notes  and  deposits  and  (b)  ultimate  convertibility  of  creditor 
liabilities  in  1825,  1829,  and  1832? 


APPENDIX  A  335 


CHAPTER  VI 

1.  What  is  the  essential  difference  between  a  bankers' 
bank  and  a  commercial  bank? 

2.  How  do  bankers'  banks  dilute  cash  reserve? 

3.  Why  is  the  term  "reserve  deposits"  not  a  contradic- 
tion in  terms? 

4.  (a)  Why  do  reserve  deposit  liabilities  tend  merely  to  be 
transferred  from  the  credit  of  one  group  of  member  banks  to 
the  credit  of  other  member  banks  as  a  result  of  lending  and 
checking  operations  and  not  to  be  withdrawn  from  the 
Federal  Reserve  banks  when  member  banks  expand  their 
loans  and  deposits? 

(b)  January  1,  1920,  the  Federal  Reserve  banks  had  sur- 
plus reserves  of  almost  exactly  .35  of  a  billion  dollars.  The 
same  banks  were  required  to  maintain  a  35  per  cent  reserve 
against  deposits.  How  much  paper  could  they  rediscount 
without  reducing  their  reserves  below  the  legal  minimum  if 
the  member  banks  took  the  entire  proceeds  in  deposits? 

5.  Notes  of  the  leading  central  banks  (bankers'  banks)  of 
Europe  are  eligible  for  use  as  reserve  by  the  commercial 
banks.  How  would  an  expansion  of  notes  of  those  central 
banks  differ  in  effect  from  an  expansion  of  Federal  Reserve 
notes? 

6.  Federal  Reserve  notes,  through  a  monetary  division 
of  labor,  make  it  possible  for  lawful  money  to  be  used  in  its 
most  inflationistic  capacity.    Explain  fully, 

7.  What  determines  whether  proceeds  of  rediscounts 
or  of  loans  will  be  taken  by  the  member  banks  in  Federal 
Reserve  notes  or  in  deposits? 

8.  Through  what  channels  do  Federal  Reserve  notes  get 
into  circulation? 

9.  Why  would  maximum  bank  credit  expansion  on  the 
books  of  member  banks  take  place  if  Federal  Reserve  note 


336  APPENDIX  A 

issues  were  kept  at  a  minimum  while  deposits  of  Federal 
Reserve  banks  were  extended  to  a  maximum? 

10.  Draw  a  diagram  showing  the  quantitative  relation 
that  would  obtain  between  cash  reserves  in  the  Federal 
Reserve  system  and  deposits  of  member  banks  if  all  loan 
expansion  of  the  Federal  Reserve  banks  took  the  form  of 
deposits  to  the  exclusion  of  notes. 

11.  Is  the  future  credit  expansion  of  member  banks 
limited  by  existing  surplus  reserves  of  the  Federal  Reserve 
banks?    Why? 

12.  What  change  or  changes  in  the  method  of  regulating 
the  reserv^e-deposits  ratio  of  commercial  banks  did  the  es- 
tablishment of  the  Federal  Reserve  system  make  possible? 

13.  Hold  in  mind  the  provision  of  the  Federal  Reserve 
Act  that  one  Federal  Reserve  bank  may  rediscount  for,  i.  e., 
lend  to,  another  and  point  out  the  way  or  ways  in  which 
the  ratio  of  cash  to  demand  liabilities  may  be  regulated  in 
the  case  of  an  individual  Federal  Reserve  bank,  and  the 
way  or  ways  in  which  that  ratio  is  regulated  in  the  case  of 
the  twelve  regional  banks  taken  as  an  aggregate. 

14.  Compare  the  volume  of  bills  discounted  by  the  Fed- 
eral Reserve  banks  for  their  members,  as  given  in  the  table 
on  page  115,  with  the  volume  of  reserv^e  deposits  on  the 
books  of  the  regional  institutions,  as  given  in  diagram  4, 
page  109. 

15.  Make  a  study  of  the  application  of  the  formulas 

c(l  ~  r^  c 

x  =  — ^^ —  and  X = to  the  operations  of  a  Federal 

kr+l-k  kr-f-l-k 

Reserve  bank. 

16.  Why  would  a  rediscount  rate  of  10  per  cent  be 
effective  in  checking  over-extension  of  loans  of  member 
banks  even  when  all  banks  were  expanding  their  loans 
simultaneously? 

17.  Indicate  the  relation  of  the  rate  of  rediscount  to  (a) 


APPENDIX  A  337 

volume  of  loans  of  member  banks,  (b)  deposits  on  the  books 
of  member  banks,  and  (c)  the  volmne  of  trade. 

18.  What  would  be  the  effect  upon  general  prices,  if, 
during  a  period  of  rising  prices  and  of  great  industrial  and 
commercial  activity,  such  as  precedes  a  crisis  or  stringency, 
an  addition  of  10  per  cent  to  the  loans  and  deposits  of  com- 
mercial banks  was  offset  by  no  perceptible  expansion  in  the 
physical  volume  of  trade,  available  productive  energy  hav- 
ing been  almost  fully  utilized  previously? 

19.  If  during  the  early  stages  of  industrial  revival,  after 
a  depression  following  a  crisis  or  stringency,  with  labor  and 
capital  only  partially  employed,  a  10  per  cent  expansion  of 
bank  loans  and  deposits  were  matched  by  a  corresponding 
expansion  in  the  physical  volume  of  trade,  what  would  be 
the  tendency  in  the  course  of  general  prices? 

20.  Whicli  is  the  more  nearly  accurate  form  of  statement : 
An  expansion  in  bank  loans  and  deposits  causes  a  rise  in 
prices,  or  that  such  an  expansion  makes  possible  a  rise  in 
prices? 

In  answering  do  not  overlook  such  considerations  as  the 
following:  Any  circumstance  (e.  g.,  additions  to  our  stock  of 
money  metal,  the  issue  of  fiat  money,  a  reduction  in  reserve 
requirements,  increased  use  of  checks),  that  tends  to  increase 
surplus  reserves  would  tend  temporarily  to  reduce  the  rate 
of  interest,  increase  business  profits,  and  stimulate  business 
expansion.  The  increased  demand  for  raw  materials,  labor 
and  commodities,  would  result  in  higher  prices  and  rising 
profits.  Rising  profits  would  give  a  further  impulse  to  de- 
mand for  goods  and  prices  would  rise  still  further.  As  prices 
rose  a  heavier  and  heavier  demand  would  be  made  upon  the 
banks  for  credit  with  which  to  finance  the  increased  volume 
of  trade.  In  time,  as  a  result  of  increased  bank  loans  and 
deposits,  the  reserve-deposits  ratio  would  become  strained, 
interest  rates  would  rise  to  a  high  point,  and  expansion  be 
brought  to  a  halt.    The  crest  of  a  wave  of  prosperity  would 


338  APPENDIX  A 

be  reached  and  passed.  (For  an  exhaustive  treatment  of 
the  business  cycle,  see  Wesley  C.  Mitchell's  admirable  work 
Business  Cycles,  The  University  of  California  Press,  1913. 
Pages  571-579  contain  a  summarized  statement  of  the  theory- 
there  developed.) 

21.  What  distinguishes  the  work  of  Federal  Reserve  banks 
from  that  of  national  and  state  banks  acting  as  bankers' 
banks  before  1914' 

CHAPTER  VII 

1.  The  use  of  endorsed  paper  led  to  endorsing  for  accom- 
modation.    Explain. 

2.  What  was  the  composition  of  the  American  banker's 
portfolio  contents  in  1860?    In  1880? 

3.  Give  an  account  of  the  forces  underlying  the  develop- 
ment of  single  name  paper. 

4.  What  main  developments  are  shown  in  diagrams  4 
and  5? 

5.  What  are  the  facts  concerning  the  note-brokerage 
business  before  the  Civil  War? 

6.  State  the  effects  of  the  depreciated  and  fluctuating 
greenbacks  upon  the  note-brokerage  business  1862-79. 

7.  Describe  the  progress  of  note  brokerage  in  the  eighteen 
hundred  and  eighties. 

8.  Compare  the  method  of  handling  paper  before  1895 
or  1900  with  that  of  1920.  Under  what  circumstances  do 
the  note  brokers  perform  a  banking  function? 

9.  Comment  on  the  time  and  circumstances  of  the  break- 
ing down  of  the  barrier  that  had  previously  prevented 
eastern  capital  from  flowing  to  the  West  through  note-brok- 
erage channels. 

10.  Characterize  the  growth  of  the  note-brokerage  busi- 
ness after  1900. 

11.  The  success  of  the  brokers  in  weaning  borrowers  away 


APPENDIX  A  339 

from  banks  created  a  corresponding  demand  among  banks 
for  the  paper  purchased.    Explain. 

12.  What  degree  of  concentration  marks  the  note-broker- 
age business? 

13.  Briefly  describe  the  internal  organization  of  a  modern 
commercial  paper  house. 

14.  What  is  the  causal  connection  between  the  seasonal 
demands  for  funds  in  United  States  and  the  growth  of  note 
brokerage? 

15.  Branch  banking  is  opposed  to  the  development  of 
note  brokerage.     Explain. 

16.  State  the  comparative  importance  of  the  bill  broker 
in  England,  France,  and  Germany. 

17.  What  is  the  main  purpose  of  the  credit  department? 

18.  Describe  the  progress  made  m  credit  research  1890- 
1900;  since  1900. 

19.  What  forces  have  underlain  the  development  and 
spread  of  the  credit  department? 

20.  Sketch  the  rise  of  the  new  business  department  and 
indicate  the  relation  between  new  business  and  credit  de- 
partments. 

21.  How  has  the  Federal  Reserve  system  affected  (a)  the 
kinds  of  our  bank  loans  and  (b)  their  quality? 

22.  The  Federal  Reserve  banks  have  been  called  the 
balance  wheel  of  the  open  market  for  bank  acceptances. 
What  is  the  significance  of  the  statement? 

23.  Our  discount  companies  in  New  York  frequently  bor- 
row in  order  to  carry  their  holdings  of  paper.  Their  usual 
trading  profit  is  said  to  be  1/16  of  1  per  cent  per  annum. 
If  a  discount  company  is  compelled  at  any  time  to  pay  6 
per  cent  for  borrowed  capital,  call  money,  how  long  a  time 
would  be  required  to  wipe  out  the  profit  of  1/16  of  1  per 
cent  on  a  sixty  day  bill  bought  at  4  per  cent  discount? 

24.  The  Guaranty  Trust  Company  of  New  York  has  fre- 
quently bought  its  own  acceptances  in  the  open  market. 


340  APPENDIX  A 

Why  might  an  institution  buy  its  own  acceptances  in  pref- 
erence to  those  of  a  competing  bank  if  there  was  no  differ- 
ence in  the  discount  rate? 

CHAPTER  VIII 

1.  What  is  a  borrower's  credit  worth? 

2.  Under  what  conditions  may  character  become  rela- 
tively inconspicuous  as  one  of  the  pillars  upon  which  bank 
credit  rests? 

3.  Enmnerate  the  principal  quick  assets  appearing  in  the 
borrower's  statement;  the  principal  fixed  assets. 

4.  Is  the  difference  between  quick  and  slow  assets  one  of 
degree  or  of  kind,  or  both?    Defend  your  answer. 

5.  What  amount  of  cash  may  be  said  to  "balance"  the 
borrower's  statement? 

6.  How  may  the  cash  item  be  adulterated? 

7.  What  is  the  imprest  cash  system? 

8.  Comment  upon  the  relation  of  the  size  of  the  bank 
balance  of  the  borrower  to  the  season  or  seasons  of  his 
trade. 

9.  What  is  meant  by  "rigging"  the  cash? 

10.  Justify  the  requirement  that  a  borrower  keep  a  bal- 
ance equal  to  15  to  25  per  cent  of  his  loans. 

11.  How  can  the  records  of  a  bank  be  made  useful  in 
throwing  light  on  the  cash  at  times  other  than  on  statement 
dates? 

12.  In  what  trades  does  the  note  still  hold  its  own  against 
the  encroachment  of  the  open  account? 

What  would  notes  in  other  lines  of  trade  indicate? 

13.  Discuss  the  relation  of  notes  and  accounts  receivable 
to  the  volume  of  sales. 

14.  What  questions  are  best  designed  to  enlighten  the 
banker  as  to  the  quality  and  value  of  the  borrower's  ac- 
counts receivable? 


APPENDIX  A  341 

15.  Why  is  the  open  account  preferable  to  the  note  from 
the  standpoint  of  taking  quick  legal  action? 

16.  Why  is  it  desirable  to  have  an  audit  by  accountants 
or  special  appraisers  follow  closely  the  annual  or  periodic 
inventory? 

17.  What  is  the  banker's  interest  in  the  location  of  the 
goods  inventoried? 

18.  Inventories  vary  widely  according  to  the  method  of 
valuation.     Illustrate. 

19.  What  is  the  most  approved  basis  of  inventory  val- 
uation? 

20.  Why  should  the  banker  object  to  the  omission  of 
both  goods  bought  and  the  liabilities  therefor? 

21.  What  is  the  objection  to  valuing  unfinished  goods  at 
cost? 

22.  What  are  the  main  facts  for  the  banker  to  bear  in 
mind  in  connection  with  the  valuation  of  real  estate,  plant 
and  machinery? 

23.  For  what  should  the  bank  credit  man  be  on  the  look- 
out in  scrutinizing  the  item  stocks  and  bonds? 

24.  Lay  down  guiding  principles  in  the  appraisal  of 
patents,  trade-marks  and  good-will. 

25.  What  are  deferred  assets?    Give  examples. 

26.  Discuss  life  insurance  as  a  contingent  asset. 

CHAPTER  IX 

1.  Classify  the  following  liabilities  as  either  current  or 
slow :  interest  on  bonds,  reserves,  sinking  fund  requirements, 
taxes,  due  from  subsidiaries,  dividends  declared  but  unpaid. 

2.  What  is  the  significance  of  a  large  amount  of  bills 
payable  in  lines  of  business  in  which  open  accounts  ordinarily 
prevail? 

3.  What  is  the  desirable  relation  between  bills  payable  to 
banks  and  bills  or  accounts  receivable? 


342  APPENDIX  A 

4.  Why  is  it  desirable  for  the  lending  banker  to  know 
the  maximum  amount  borrowed  from  all  sources  during  the 
previous  fiscal  year? 

5.  Why  is  the  amount  of  "bills  payable  for  paper  sold" 
less  likely  to  be  understated  now  than  in  1905  ? 

6.  Indicate  the  importance  to  the  banker  of  discovering 
how  the  amount  of  accounts  payable  is  ascertained. 

7.  If  offsetting  accounts  payable  by  accounts  receivable 
does  not  change  the  net  worth,  why  is  the  practice  objec- 
tionable? 

8.  What  phases  of  ''bonded  debt  and  interest  thereon" 
ought  especially  to  engage  the  attention  of  the  banker? 

9.  What  is  the  significance  of  an  overlapping  mortgage? 
Of  a  thin  equity? 

10.  (a)  Why  does  the  item  "deposits  of  money  with  us" 
deserve  close  scrutiny? 

(b)  What  is  the  answer  to  the  contention  of  those  who 
urge  that  this  item  indicates  additional  security,  as  those 
closely  interested  are  shown  to  be  willing  to  entrust  their 
money  to  the  concern  in  question? 

11.  To  treat  contingent  liabilities  as  current  liabilities  is 
very  unfavorable  to  the  borrower.    Explain. 

12.  Give  examples  of  accrued  liabilities.  How  do  they 
differ  from  deferred  liabilities? 

13.  What  importance,  if  any,  is  to  be  attached  to  the 
absence  of  accrued  liabilities  in  the  borrower's  statement? 

14.  Distinguish  capital  and  surplus  from  net  worth. 
Why  should  the  lending  banker  be  interested  in  the  size  of 
the  proprietorship  interest? 

15.  Comment  upon  the  proper  ratio  of  quick  assets  to 
current  liabilities.  Cite  cases  in  which  variation  from  the 
usual  ratio  would  be  justifiable? 

16.  If  you  were  a  lending  banker,  whom  would  you  re- 
quire to  keep  the  higher  ratio  of  quick  assets  to  current 
liabilities,  a  wholesale  grocer  or  a  wholesale  milliner?  Sugar 


APPENDIX  A  343 

planters  or  roasters  and  jobbers  of  coffee?    Retailers  of  hard- 
ware or  of  groceries  and  green  vegetables?    Why? 
17.  A  given  firm  shows  the  following  condition: 

Feb.  1st  April  1st 

Cash $20,000  $    7,000 

Bills  Receivable 120,000  63,000 

Merchandise 220,000  170,000 


Total  Quick  Resources S360,000  240,000 

Accounts  Payable $110,000  $  40,000 

Other  Current  Debts 90,000  40,000 


Total  Current  Debt $200,000  $  80,000 

Ratio  of  Quick  Assets  to  Current 
Liabilities 180  per  cent         300  per  cent 

(a)  How  might  the  condition  of  April  1st  grow  out  of  that 
of  February  1st? 

(b)  If  the  borrower  submitted  the  figures  for  April  1st 
as  a  part  of  his  statement  to  his  banker,  what  additional 
information  or  maximum  figures  for  the  year  would  place 
the  banker  in  a  position  to  avoid  lending,  the  condition  of 
February  1st  being  normal? 

(c)  Would  this  extreme  case  indicate  that  the  ratio  of 
quick  assets  to  current  obligations  ought  itself  to  be  tested? 

18.  Statements  of  a  given  concern  for  two  successive 
years  show  the  same  ratio  of  quick  assets  to  current  liabili- 
ties, but  the  ratio  of  merchandise  to  receivables  is  3  to  2  the 
first  year  and  2  to  3  the  second.  If  merchandise  is  carried  at 
cost  and  receivables  at  their  face  value,  which  includes  profit 
on  merchandise  sold,  which  year's  statement  is  the  stronger 
from  the  standpoint  of  the  lending  banker? 

19.  Working  capital  is  quick  assets  minus  current  liabili- 
ties.   Why  might  a  period  of  depression  have  very  adverse 


344  APPENDIX  A 

effects  upon  a  concern  whose  ratio  of  working  capital  to 
fixed  assets  was  low? 

Would  an  examination  of  the  yearly  changes  in  this 
ratio  throw  light  on  whether  the  concern  was  gradually 
converting  quick  into  fixed  assets? 

20.  What  is  a  proper  or  safe  relation  of  net  worth  to  credit 
worth? 

CHAPTER  X 

1.  What  is  the  effect  upon  profits  of  capitalizing  repairs 
and  maintenance?  Of  charging  additions  and  betterments 
to  repairs  and  maintenance? 

2.  What  is  the  advantage  to  the  banker  of  comparing  the 
borrower's  income  accounts  over  a  period  of  years? 

3.  What  advantage  in  analyzing  the  income  account 
has  the  large  bank  with  several  customers  in  the  same  line 
of  trade  over  the  small  bank  whose  customers  are  few? 

4.  On  what  grounds  does  the  lending  banker  object  to 
the  borrower's  failure  to  insure  fire  risks  adequately? 

5.  What  is  the  banker's  interest  in  salaries  paid  and  cash 
withdrawn? 

6.  How  may  "depreciation"  conceal  "unearned"  prof- 
its? Mention  other  methods  of  concealing  losses  or  slender 
earnings? 

7.  Characterize  the  financial  and  accounting  policy  of  the 
New  England  cotton  mills. 

8.  Compare  or  contrast  the  following  lines  of  industry  as 
to  proper  charges  for  depreciation:  clothing  manufacture, 
shoe  manufacture,  lumber  manufacture. 

9.  Why  is  the  item  of  sales  important  to  the  lending 
banker? 

10.  Five  years  ago  firm  A  had  receivables  of  $150,000  and 
sales  of  $900,000  per  year,  terms  being  60  days  net;  this 
year,  receivables  are  $120,000  and  sales  $1,000,000,  terms 


APPENDIX  A  345 

being  30  days  net.    In  which  case,  presumably,  is  the  qual- 
ity ot  the  receivables  the  higher? 

11.  What  would  be  your  interpretation  of  increasing  sales 
from  year  to  year  coupled  with  a  declining  ratio  of  sales  to 
merchandise? 

12.  Where  sales  terms  are  sixty  days  net,  how  would 
the  sales  to  receivables  ratio  stand  if  the  statement  were  as 
of  a  date  representing  the  peak  of  the  selling  season?  (Re- 
minder: Sales  relate  to  a  'period  of  time;  receivables  to  an 
instant  of  time.) 

13.  If  sales  terms  of  a  given  firm  having  sales  of  $1,800-, 
000  are  two  per  cent  discount  in  ten  days  and  30  days  net, 
at  what  amount,  roughly,  ought  the  receivables  to  stand? 

14.  Why  ought  the  credit  man  of  the  bank  look  carefully 
into  the  ratio  of  net  worth  to  sales? 

What  is  over-trading? 

15.  One  manufacturer  of  brushes  has  a  capital  investment 
of  $100,000,  sales  of  $300,000  and  net  profits  of  $20,000. 
Another  has  a  capital  of  $100,000,  sales  of  $500,000  and  net 
profits  of  $20,000.  If  the  moral  risk  and  other  factors  are 
equally  good  in  the  two  cases,  which  manufacturer  has  the 
higher  credit  worth? 

Which  is  the  more  important  from  the  standpoint  of  the 
lending  banker,  the  ratio  of  net  profits  to  sales  or  the  ratio  of 
net  profits  to  capital  investment? 

16.  Why  should  an  unbroken  symmetrical  gain  in  net 
profits  put  the  banker  on  his  guard? 

17.  Illustrate  the  importance  of  collateral  information  in 
regard  to  earnings. 

18.  Under  what  conditions  may  dividends  be  much  less 
than  earnings  and  still  be  improper? 

19.  Outline  three  or  more  reflex  benefits  of  bank  borrow- 
ers' statements. 

20.  Why  do  some  borrowers  refuse  to  render  statements? 

21.  A  wool  house  has  the  following  assets  and  liabilities: 


346  APPENDIX  A 

cash  $189,000,  accounts  receivable  $382,500,  inventory 
$1,236,550,  marketable  securities  $353,500,  advances  on  wool 
bought  $298,500,  real  estate  $20,000,  equipment  and  machin- 
ery $16,000,  other  fixed  assets  $9,000,  bills  payable  $722,325, 
acceptances  (payable)  $216,510,  accounts  payable  $831,550, 
reserves  $294,000,  deposits  of  money  $64,500. 

What  is  the  ratio  of  quick  assets  to  current  liabilities? 
What  is  the  net  worth? 

22.  The  following  statement  is  that  of  a  wholesale  grocery 
house  and  is  taken  at  a  representative  date: 

Assets  Liabilities 

Cash $   406,826.32    Bills  Payable $1,100,000.00 

Accounts 

Receivable 1,806,715.14  Accounts  Payable .      206,530.45 

Merchandise 1,783,945 .  60  Money  on  Deposit     723,942 .  19 

Real  Estate 1,643,000.00  First    Mortgage 

Machinery,  Trucks,  Bonds 1,500,000 .  00 

Wagons,  etc. . . .      157,435 .  00  Preferred  Stock ...   1 ,500,000 .  00 

Good-will 1,000,000. 00  Common  Stock. .  .    1,000,000 . 00 

Surplus 767,449.42 

$6,797,922.06  $6,797,922 .  06 

Sales $19,448,860.00 

(a)  What  is  the  ratio  of  quick  assets  to  liabilities? 

(b)  What  evidence  is  there  that  the  concern  discounts 
its  bills? 

(c)  What  would  the  turnover  indicate  as  to  the  quality 
of  the  merchandise? 

(d)  How  much  could  be  realized  on  good-will  in  the  event 
of  failure? 

(e)  The  indenture  covering  the  bonds  overlaps  from 
real  estate  to  merchandise  and  other  quick  assets,  but  the 
assets  back  of  the  bonds  are  sound  and  saleable.  Is  the 
overlapping  feature  a  weakness?    What  items  in  the  state- 


APPENDIX  A  347 

ment  might  cause  a  banker  to  suspect  an  overlapping  inden- 
ture? 

Are  there  any  other  elements  of  weakness  in  the  state- 
ment? 

(f)  The  moral  risk  being  sound,  what  is  the  amount  up 
to  which  you  would  be  willing  as  a  lending  officer  to  extend 
further  credit? 

23.  Draw  up  the  financial  statement  of  a  corporation 
engaged  in  the  manufacture  of  edge  tools  with  a  capital 
stock  of  $100,000  and  other  items  of  such  magnitude  and 
in  such  proportion  as  to  give  the  concern  a  credit  worth  of 
$100,000,  the  moral  risk  being  sound. 

24.  Calculate  the  credit  worth  of  the  American  Agricul- 
tural Chemical  Company  whose  certified  balance  sheet  and 
income  account  are  subjoined,  assuming  the  moral  risk  to 
be  excellent. 

BALANCE   SHEET,   JUNE   30.    1919 

INCLTJDINQ    SDB8IDIARY    COMPANIES 

Assets 

Land,  Buildings  and  Machinery $16,918,681.18 

Equipment  and  Floating  Property 4,369,278.50 

Mining  Properties 19,487,800.85 

Other  Investments 6,411,521.15 

Brands,  Trade-Marks,  Patents,  Good- Will,  etc 1 .  00 

Total  Capital  Assets $  47,187,282.68 

Sinking  Fund: 

For  Redemption  of  Bonds $  3,513,111.22 

Less  Bonds  Purchased,  Interest  and  Premium 3,512,076.05 

$  1,035.17 

Deferred  Assets: 

Unexpired  Insurance,  Taxes,  Licenses,  etc $      379,345.60 

Guaranteed    Accounts    Receivable,    incomplete    new 
construction,   expenditures  chargeable   to  future 

operations,  etc 2,351,680.31 

Advance  Payments,  Merchandise  Purchased 163,206.38 

$    2,894,238.29 

Accounts  Receivable 826,168,066.54 

Notes  Receivable 10,217,3.38.27 

Inventories  (Merchandise  and  Supplies) 19,514,430.45 

Caah  in  Banks,  on  hand  and  in  transit 2,526,184.44 

U.  8.  Bonds  and  Notes 2,225,000.00 

Total  Current  Assets $  60,651,019.70 

$110,733,.575.84 


348  APPENDIX  A 

Lidbilitiea 
Capital  Liabilities: 

Preferred  Stock $50,000,000 .  00 

Less  Unissued 21,615,800.00 

$28,384,200.00 

Common  Stock $50,000,000.00 

Less  Unissued 18,344,800.00 

$31,655,200.00 


Total  Capital  Stock  Outstanding $  60,039,400.00 

First  Mortgage: 

5%  20-Year  Convertible  Gold  Bonds,  due  Oct.  1, 

1928 12,000,000.00 

Less  Bonds  Purchased  for  Sinking 

Fund $  3,415,000.00 

Less  Bonds  Converted  into  Preferred 

Stock 1,142,000.00 

4,557,000.00 


Total  First  Mortgage  Bonds  Outstanding $     7,443,000.00 

Debenture  Bonds: 

5%  Convertible  Gold  Debenture  Bonds,  due  Feb.  1, 

1924 $15,000,000.00 

Less  Bonds  Converted  into  Common  Stock $  3,739,900.00 

Less  Unissued 5,900,000.00 

$  9,639,900.00 


Total  Debenture  Bonds  Outstanding $     5,360,100.00 

Deferred  Liabilities: 

Reserve  for  Doubtful  Debts  and  Contingencies.  .  .  .$  532,832.64 

Reserve  for  Property  Depreciation 1,241,126.96 

Reserve  for  Property  Renewals 276,739.92 


Current  Liabilities: 

Accounts  Payable  and  Accrued  Taxes $  2,855,011 .03 

Notes  Payable 12,887,500.00 

Notes  Payable  (secured  by  U.  S.  Bonds  and  Notes) .  .     2,030,000.00 

Accrued  Freights  and  Discounts 782,680.58 

Accrued  Interest  on  Bonds 204,706 .  25 


$     2,050,699.52 


Total  Current  Liabilities $  18,759,897 .  86 

Surplus,  June  30,  1919 17,080,478.46 

$110,733,575  84 


INCOME   ACCOUNT 
FOR  THE   YEAR   ENDED    JUNE    30,    1919 

Surplus  at  June  30,  1918 $16,394,829.90 

Income  (including  profits  of  subsidiary  companies) 
after  deducting  operating  charges.  Plus  Taxes 
($2,123,836.05)  which  include  Federal  Taxes  for 
the  Calendar  Year  1918 $  8,035,854.30 

Income  from  Other  Sources 170,274 .  07 


Total  Income $  8,206,128.37 

Deduct: 

Interest  on  Mortgage  Bonds $      404,001.36 

Interest  on  Debenture  Bonds 380,784 .  34 

For  Freights,  Losses  and  Contin- 
gencies          968,463.06 

For  Factory  Depreciation  and  Mining 

Depletion 2,294,209 .  52 

$  4,047,458.28 


Net  Profit  for  the  Year $  4,158,670.09 


APPENDIX  A  349 

D«ducl: 

Dividends  on  Preferred  Stock $  1,659,896.33 

Dividends  on  Common  Stock 1,813,125.20 

S  3,473,021.53 

SurpliiB  for  the  Year 685,648.56 

Surplus  June  30,  1919 $17,080.478.46 

Profits  and  Dividends  Since  Organization,  189S 

Total  Profits  to  June  30,  1918 $53,679,003.66 

Profit  for  the  year  ended  June  30,  1919 4,158,670.09 

Total  Profits,  June  30,  1919 $57,837,673 .  75 

Deduct: 

Dividends  on  Preferred  Stock $25,752,923 .  12 

Dividends  on  Common  Stock 7,047,692.37 

$32,800,615.49 

Deductions  to  June  30,  1919 7,956,579.80 

$40,757,195.29 

Surplus,  June  30,  1919 $17,080,478 .  46 

25.  Read  carefully  Appendix  B  and  note  any  important 
considerations  not  dwelt  upon  in  chapters  VIII-X. 

CHAPTER  XI 

1.  Of  what  use  would  the  Textile  Trade  Directory  be 
to  a  credit  man  about  to  investigate  the  credit  standing 
of  a  prospective  customer  engaged  in  the  manufacture  of 
woolens? 

2.  In  what  respects  are  the  reports  of  mercantile  agencies 
of  value  to  the  bank  credit  man? 

3.  Why  is  the  class  of  firms  from  which  a  house  buys 
goods  a  good  index  of  credit  standing? 

4.  Why  does  the  mercantile  credit  man  not  begrudge 
time  spent  in  being  interviewed  by  the  bank  credit  man? 

5.  What  are  the  most  important  questions  the  investi- 
gator representing  the  bank  credit  department  can  ask? 
The  most  important  single  question? 

6.  In  what  ways  may  the  banker  avail  himself  of  the 
advice  of  the  trade  expert? 

7.  State  the  main  facts  concerning  banks  as  sources  of 
credit  information  stressing  (a)  the  reciprocal  value  of  in; 


350  APPENDIX  A 

quiries,  (b)  the  credence  of  the  banker's  testimony,  (c)  the 
difficulty  of  obtaining  first  hand  information, 

8.  Formulate  interview  questions  bearing  upon  the 
following  aspects  of  the  bank  customer's  business: 

Profits,  dividends,  business  experience,  reserves,  Ufe 
insurance,  accounts  receivable  pledged,  rate  of  interest  paid 
on  "money  on  deposit  with  us,"  proportion  of  capital  paid 
in  by  notes,  outside  interests  of  partners,  minimum  bank 
borrowings,  other  bank  accounts,  sales  and  sales  terms, 
contingent  liability. 

9.  Describe  the  way  in  which  the  credit  department  of 
a  metropolitan  bank  would  investigate  the  credit  standing 
of  the  Turnbull  Wagon  Company  located  at  Defiance, 
Ohio. 

CHAPTER  XII 

1.  What  are  the  principal  classes  of  secured  loans? 

2.  Compare  the  interest  of  the  New  York  banker  in 
securities  offered  as  collateral  with  the  interest  of  a  banker 
at  Baltimore,  Indianapolis  or  El  Paso. 

3.  Comment  on  the  importance  of  safe  or  full  margin 
in  connection  with  collateral  loans. 

4.  Why  are  fife  insurance  policies  superior  to  stocks  and 
bonds  as  security? 

5.  What  was  the  probable  origin  of  loans  on  warehouse 
receipts  as  security? 

6.  What  are  the  chief  factors  affecting  the  safety  of  loans 
on  warehouse  receipts? 

7.  What  is  the  advantage  to  the  banker  of  using  receipts 
based  on  one  bale  lots  in  connection  with  cotton  loans? 

8.  What  rules  may  well  guide  the  banker  in  making  crop 
loans? 

9.  On  what  valuation  ought  an  urban  real  estate  loan  to 
be  made? 


APPENDIX  A  351 

10.  Why  are  vacant  properties  dangerous  as  security  for 
loans?    A  costly  property  in  a  poor  neighborhood? 

11.  Enumerate  and  appraise  the  most  important  circum- 
stances affecting  the  value  of  farm  land  as  security. 

12.  Wliy  are  loans  on  high-priced  land  likely  to  be  sounder 
than  those  on  low-priced  tracts? 

CHAPTER  XIII 

1.  How  does  the  "  cash  credit "  of  Scotland  differ  from 
the  American  overdraft? 

2.  Classify  overdrafts  with  reference  to  the  offenders. 

3.  What  is  the  relation  between  bank  competition  and 
overdrafts? 

4.  Why  are  overdrafts  an  objectionable  form  of  credit 
advance? 

5.  Compare  national  and  state  banks  as  to  ratio  of  over- 
drafts to  loans;  trust  companies  and  private  banks. 

6.  Which  rules  given  for  controlling  overdrafts  would 
be  of  greatest  value  to  a  newly  established  bank?  Which  to 
an  old  institution? 

7.  Cite  evidence  that  overdrafts  are  a  function  of  bank 
supervision. 

8.  Would  a  bank  examiner  finding  a  customarily  large 
overdraft  item  on  the  books  of  a  bank  under  examination  be 
justified  in  reversing  his  usual  benevolent  assumption  that 
loans  are  sound? 

CHAPTER  XIV 

1.  Why  is  the  countiy  banker  justified  in  giving  more 
consideration  to  character  and  capacity  and  less  to  the 
capital  of  the  borrower  than  would  the  city  banker? 

2.  Compare  the  selective  power  exercised  in  the  choice 
of  customers  by  the  First  National  Bank  of  Boston  and  the 
First  National  Bank  of  Wahoo,  Nebraska. 


352  APPENDIX  A 

3.  Why  does  the  balance  of  the  typical  country  bank 
borrower  run  low  as  compared  with  the  same  in  city  banks? 

4.  Characterize    the    country    banker's    demand    loans 
against  collateral. 

5.  What  are  "sleepers?"    Why  are  they  more  common  in 
the  country  than  in  city  banks? 

6.  Under  what  conditions  might  a  country  bank  have  no 
loans  in  its  financial  statement? 

7.  Under  what  conditions  ought  the  banker  to  renew 
paper? 

8.  Why  is  single-name  paper  less  productive  of  past-due 
paper  than  is  double-name? 

9.  In  what  way  is  the  note  ledger  a  spur  to  prompt  retire- 
ment of  loans? 

10.  What  other  measures  can  you  mention  as  conducive 
to  prompt  payment? 

11.  Under  what  conditions  ought  loans  to  tenants  prove 
advantageous  to  the  banker? 

12.  Is  the  country  banker  justified  in  charging  higher 
rates  than  the  city  banker?    Why? 


CHAPTER  XV 

1.  State  and  explain  methods  by  which  one  bank  may 
lend  to  another. 

2.  If  unrated  paper  is  that  the  maker  of  which  is  not  rated 
by  the  mercantile  agencies,  why  does  it  compare  favorably 
with  rated  paper  as  collateral  security  in  the  estimation  of 
the  lending  banker? 

3.  What  is  non-liability  paper? 

4.  Along  what  lines  does  the  representative  of  a  metro- 
politan bank  attempt  to  secure  credit  information  at  bank- 
ers' conventions? 

5.  The  way  in  which  a  borrowing  bank  handles  its  ac- 


APPENDIX  A  353 

count  with  the  city  correspondent  is  a  significant  indication 
of  the  character  of  the  borrowing  institution.    AmpHfy. 

6.  Give  an  account  of  the  method  of  investigation  em- 
ployed by  a  bank  in  New  York  preparatory  to  making  a  loan 
to  one  of  its  correspondents. 

CHAPTER  XVI 

1.  Account  for  the  prevalence  of  the  partnership  form  of 
organization  among  note  brokerage  houses. 

2.  The  resourcefulness  of  the  note  broker  is  as  important 
as  his  resources.    Explain. 

3.  What  are  the  principal  kinds  and  relative  proportions 
of  paper  passing  through  the  hands  of  our  note  brokers? 

4.  What  are  the  usual  denominations  of  broker's  paper? 
Why? 

5.  Explain  fully  what  is  meant  by  buying  paper  on  seven 
or  ten  days'  option. 

6.  What  is  the  broker's  commission?  Why  may  he  make 
more  or  less  than  his  commission? 

7.  What  is  the  significance  of  the  fact  that  the  broker's 
commission  is  without  respect  to  the  time  the  note  has  to 
run? 

8.  Analyze  the  advantages  of  broker's  paper  to  borrowers. 

9.  What  are  the  disadvantages  of  broker's  paper  to  the 
borrower? 

10.  Analyze  the  advantages  of  broker's  paper  to  buy- 
ing banks. 

11.  How  high  a  premium  does  the  banker  have  to  pay  for 
broker's  paper  as  compared  with  "straight"  paper? 

12.  Explain  carefully  the  control  exercised  by  the  note 
brokerage  houses  over  our  banks. 

13.  Why  is  the  note  broker  at  any  given  time  under  an 
inducement  to  depress  money  rates?  How  has  he  attained 
this  end? 


354  APPENDIX  A 

14.  The  note  brokerage  system  has  tended  to  equalize 
discount  rates  territorially.  Can  as  much  be  said  of  the 
sj^stem  in  relation  to  periods  of  time? 

15.  Under  what  conditions  during  a  period  of  tight 
money  would  the  proceeds  of  bank  loans  made  directly  to 
borrowers  returning  from  the  brokers'  fold  "go  straight  into 
the  reserve"  of  banks  in  other  communities? 

16.  If  money  rates  were  high  in  the  St.  Louis  district 
and  low  in  the  Cleveland  district,  would  the  purchase  of  St. 
Louis  paper  by  banks  in  the  Cleveland  district  tend  to  set 
up  a  flow  of  bank  reserves  from  Cleveland  to  St.  Louis? 
Explain  in  detail,  assuming  that  the  paper  passes  through 
a  note  brokerage  house  of  Chicago. 

17.  Why  is  the  note  brokerage  system  favorable  to  over- 
expansion? 

18.  How  was  it  possible  for  the  H.  B.  Claflin  Company  to 
borrow  so  heavily  and  so  widely? 

19.  Describe  and  appraise  methods  designed  to  correct 
the  weaknesses  inherent  in  the  note  brokerage  system. 

CHAPTER  XVII 

1.  Contrast  internal  and  external  bank  examination  as  to 
purpose  or  object. 

2.  Characterize  our  national  bank  supervision  prior  to  1907. 

3.  What  have  been  the  main  improvements  inaugurated 
in  the  system  of  examination  since  1907. 

4.  Along  what  lines  has  improvement  been  effected  in 
state  bank  supervision. 

5.  To  what  extent  is  cooperation  the  rule  among  our 
supervising  agencies? 

6.  What  was  the  origin  of  clearing  house  bank  examina- 
tion? 

7.  What  are  the  main  features  of  the  system  of  clearing 
house  bank  examination? 


APPENDIX  A  355 

8.  What  merits  are  peculiar  to  the  clearing  house  system 
of  bank  examination? 

9.  What  has  been  the  effect  of  clearing  house  examination 
upon  the  loans  of  small  banks? 

10.  How  has  clearing  house  bank  examination  reduced 
double  or  multiple  borrowing? 

11.  What  incidental  effects  on  loans  and  on  banks  may 
be  traced  to  clearing  house  bank  examination? 

12.  What  are  the  weaknesses  of  the  various  forms  of  inter- 
nal bank  examination? 

13.  Describe  the  system  of  examination  by  accountants 
for  banks  in  Group  1  of  the  New  Jersey  Bankers'  Associa- 
tion. 

14.  Why  ought  bank  examination  by  directors  be  wel- 
comed by  state  banking  departments? 


APPENDIX  B 

REPORT  OF  COMMITTEE  ON  CREDIT  FORMS^ 

Made  to  the  American  Bankers'  Association  at 
Atlantic  City,  N.  J.,  September  28,  1917 

Your  Committee  on  Credit  Forms  practically  completed 
its  labors  when  the  three  specimen  forms  were  submitted  to 
the  membership  of  the  Association  through  the  medium  of 
the  Journal  Bulletin.  A  final  report  has  been  withheld  until 
this  time,  that  the  committee  might  have  the  benefit  of  any- 
constructive  criticism  offered,  and  it  is  pleased  to  state  that 
several  suggestions  have  been  received  which  it  has  adopted 
and  included  in  the  amended  and  improved  forms  which  are 
submitted  as  a  part  of  this  report. 

The  committee  desires  to  make  special  mention  for  the 
suggestion  of  two  items,  "a  condensed  statement  of  profit 
and  loss  account  for  the  past  fiscal  year"  and  "a  reconcile- 
ment of  the  net  worth  or  surplus"  which  was  recommended 
by  the  Executive  Committee  of  the  Clearing  House  Section. 

As  stated  in  the  preliminary  report  made  to  the  Executive 
Council  some  months  ago,  your  committee  has  conducted  an 
exhaustive  investigation  into  the  different  forms  now  used 
in  the  various  lines  of  business  and  in  many  different  sec- 
tions of  the  country,  with  the  conclusion  that  a  universal 
standardization  of  forms  is  practically  an  impossibility. 
Certain  fundamental  principles  were  embodied  in  the  forms 

1  Journal  of  the  American  Bankers'  Association,  Vol.  10,  No.  5, 
Nov.,  1917,  pp.  351-356. 

356 


APPENDIX  B  357 

we  examined  and  with  these  ideas  as  a  basis,  three  different 
forms  have  been  prepared  which  your  committee  beHeves 
are  sufficient  to  cover  practically  all  cases. 

The  first  of  these  forms  is  for  the  farmer  or  individual ;  the 
second  for  the  firm  or  individual  engaged  in  the  mercantile 
or  manufacturing  business;  and  the  third  for  the  corporation 
engaged  in  mercantile  and  manufacturing  lines. 

In  compiling  these  forms,  it  has  been  the  aim  of  the  com- 
mittee to  elicit  all  the  information  necessary  to  obtain  an 
intelligent  insight  into  the  financial  and  other  conditions  of 
the  individual  or  business  under  consideration  and  at  the 
same  time  to  make  its  questions  as  brief  and  simple  as  pos- 
sible. 

Your  committee  has  received  voluntary  suggestions  in 
such  large  numbers  as  to  show  conclusively  the  work  had 
enlisted  the  interest  of  many  of  your  members,  and  while 
some  of  the  suggestions  offered  were  impracticable,  others 
have  been  found  to  be  of  extraordinary  merit.  The  one 
predominating  idea,  however,  coming  from  banks  both  large 
and  small,  was  for  brevity  and  simplicity  in  the  forms  to  be 
adopted.  This  demand  has  caused  the  committee  to  elimi- 
nate a  number  of  ideas  of  its  own  and  to  reject  suggestions 
coming  from  others  which  contain  considerable  merit. 

Your  committee  fully  realizes  that  the  forms  adopted  will 
not  meet  the  need  of  every  bank  or  banker  in  this  great 
country  where  local  conditions  and  requirements  vary  so 
greatly.  It  is  the  belief,  however,  that  the  forms  submitted 
will  meet  the  needs  of  thousands  of  your  members,  and  that 
minor  changes  to  meet  individual  or  local  needs  will  make 
them  desirable  to  practically  every  bank  in  this  Association. 

If  the  result  of  our  work  is  adopted  by  this  Association,  it 
is  the  suggestion  of  the  committee  that  samples  of  the  forms 
be  printed  and  placed  on  file  in  the  General  Secretary's  office 
in  New  York  to  be  furnished  to  members  who  desire  them 
for  "copy." 


358  APPENDIX  B 

Your  committee,  believing  it  has  now  accomplished  the 
end  for  which  it  was  formed,  asks  to  be  discharged. 

Respectfully  submitted. 
Nelson  N.  Lampert, 
Wm.  a.  Law, 
W.  P.  Sharer,  Chairman. 

The  action  of  the  Convention  was  as  follows: 

President  Goebel:  Gentlemen,  you  have  heard  the  most 
excellent  report  of  this  committee.  What  is  your  pleasure? 
Unless  there  is  objection,  the  report  will  be  received  with 
approval  and  the  committee  discharged,  as  requested,  with 
thanks.    The  Chair  hearing  no  objection,  it  is  so  ordered. 

Note:  All  members  are  privileged  to  use  these  forms  by 
having  them  printed  hy  their  local  printer,  but  with  the 
understanding  that  a  notice  be  printed  thereon  stating  that 
they  are  the  forms  of  the  Association. 

The  forms  referred  to  in  the  report  of  the  committee  fol- 
low on  succeeding  pages. 

FORMS  DESIGNED  AND  APPROVED  BY  THE  AMERICAN 
BANKERS'  ASSOCIATION 

Form  No.  1 

Farmer 

Statement  of 

Address 

To Bank  of 


I  make  the  following  statement  of  all  my  assets  and  liabilities  as 

at  the  close  of  business  on and  give  other  material 

information  for  the  purpose  of  obtaining  advances  on  notes  and  bills 
bearing  my  signature  or  indorsement  and  for  obtaining  credit 
generally  upon  present  and  future  applications.  If  any  change 
materially  reduces  my  means  I  will  immediately  notify  the  bank. 


APPENDIX  B  359 

(Please  answer  all  questions  and  fill  in  all  blanks) 

Assets  Liabilities 

Cash  on  hand  and  in  bank Accounts  and  notes  owed  by  me 

Loans  and  accounts  due  to  me  without  security . 


(good) Notes  or  mortgages  owed  by  me 

Farm  products with  real  estate  as  security 

Live  stock Notes  owed  by  me  with  chattel 

Farm  land  and  buildings  (see  mortgage  as  security 

schedule) Other  indebtedness  (itemized)  .  .  . 

Farm  implements  and  machinery . 


Other  property  (itemized) Total  Liabilities 

Net  Worth 


Total. 


Total . 


Location  of  Land  Owned        Acres        Estimated  Value        Assessed  at        Mortgaged  for 


Title.    The  title  to  all  above  described  real  estate  is  in  my  name 
solely,  except  as  follows: 


Buildings.    State  general  character Contingent  Liability  as  indorser  or 

guarantor $. 

Implements.     State    general    character  of  Accounts    and    Notes    Payable.     (If 

those  listed  as  assets any  are  past  due  state  amounts 

and  reasons) 

Insurance.    Fire  $ Life  $ Other  Liens.     (If  any  other  liens  on 

Who  is  beneficiary? assets,  state  amount  and  circum- 
stances)   


I  hereby  certify  that  the  figures  and  statements  contained  on  both 
sides  of  this  sheet  are  true  and  give  a  correct  showing  of  my  financial 
condition. 
Signed  this day  of 19.  .    Name 

Reverse  Side  of  Form  No.  1 
State  character  of  loans  and  accounts  listed  as  assets 


If  any  leased  land  used,  state  acreage,  nature,  use  and  terms  of 
rental 


360  APPENDIX  B 


(The  balance  of  this  space  may  be  used  for  printing  any  questions 
desired  to  be  asked  amplifying  statement  of  condition  as  shown  on 
opposite  page.) 

Form  No.  2 

Firm  or  Individual 
Manufacturer  or  Merchant 

Name Business 

Address 

To  the Bank 

For  the  purpose  of  procuring  and  maintaining  credit  from  time  to 

time  in  any  form  whatsoever  with  the Bank, 

for  claims  and  demands  against  the  undersigned,  the  undersigned 
subnodts  the  following  as  being  a  true  and  accurate  statement  of 

financial  condition  on  the day  of , 

19 .  .  and  agree  that  if  any  change  occurs  that  materially  reduces  the 
means  or  ability  of  the  undersigned  to  pay  all  claims  or  demands 

against the  undersigned  will  immediately  and  without 

delay  notify  the  Bank;  and  imless  the  Bank  is  so  notified,  it  may 
continue  to  rely  upon  the  statement  herein  as  a  true  and  accurate 
statement  of  the  financial  condition  of  the  undersigned. 

Assets  Liabilities 

Cash  on  hand  and  in  bank Due  on  open  accounts 

Accounts  of  customers  (good) Acceptances: 

Notes  and  acceptances  of  customers  (1)   Issued  in  payment  for  mer- 

(good) chandise 

Merchandise  (at  cost) :  (2)   Other  acceptances 

(1)  Manufactured Notes  payable  for  merchandise. .  . 

(2)  Raw  material Notes  payable  to  own  banks 

(3)  Stock  in  process Notes  sold  through  brokers 

Due  from  partners  notes,  accounts  Notes  payable  to  others 

receivable,  etc Money  on  deposit  with  us 

Plant  and  machinery Other  current  debts  (itemized) .... 

Furniture  and  fixtures 

Real  estate  (value-mortgage  en-  Debt  secured  by  mortgage — when 

tered  in  liabilities) due 

Other  assets  (itemized) Net  worth 

Reserves 

Notes  receivable  and  acceptances, 

discounted  or  sold  with  endorse- 

ment  or  guarantee  (contingent 

liability) 


Total Total. 


APPENDIX  B  361 

Between  the  date  of  the  above  inventory  and  the  present  tune  we 
have  had  no  serious  losses  through  bad  debts  or  otherwise  (except) 

and  our  condition  to-day  is  fully  as  good  as  set 

forth  by  the  above  figures. 

Condensed  Profit  and  Loss  Statement  for  Fiscal  Year  Ending 
19... 


Expense                                                                   Income 
Cost  of  material  or  merchandise  Net  sales 

consumed From  investments 

Actual  expense  of  conducting.  .  .  .  From  discounts  on  purchases. 

business.    Including  rent,  taxes,  From  other  sources — itemize. . 

insurance,  etc 

Salary  drawn  by  myself 

Interest  on  borrowed  money , 

Bad  debts  charged  off 

Depreciation  charged  off 

Net  profits 


Total Total . 


Reconcilement  of  Net  Worth 

Net  worth  at  close  of  previous  fiscal  year S 

Less  charges  not  applicable  to  current  year $ $. 


Add  net  profits  as  above $ J . 

Less — withdrawals,  other  than  salary  as  above $ . 

Net  worth %. 


Reverse  Side  of  Form  No.  2 

Contingent  Liability:  We  have  no  contingent  liability  of  any  kind  as 

endorser  or  guarantor  not  noted  above  (except  as  follows) 

Our  merchandise  is  insured  for  $ Plant,  building  and  ma- 
chinery $ Life  insurance  carried  for  $ Bene- 
ficiary      None  of  the  accounts  or  notes  receivable 

included  in  the  within  statement  have  been  assigned,  pledged  or 
discounted  (except  as  follows) 

Neither  have  any  of  our  other  assets  been  pledged  or  assigned  as 
collateral  for  any  of  our  liabilities  (except  as  follows) 


Our  partnership  terminates . 


362  APPENDIX  B 

We  have  no  interest  in  any  other  concern  (except — name  affihations 

and  location) 

There  are  no  suits  pending  against  our  firm  (except) 

The  form  of  obligation  used  in  the  financing  of  our  business  is  the 

plain  note  of  the  firm  (endorsed  by) 

None  of  the  endorsers  guarantee  or  endorse  the  paper  of  other  con- 
cerns or  individuals  (except) 

Outside  resources  of  endorsers  are 

_        I  commercial  paper  is  1     ,       ,    ,         ,    ,  ,     ,  ,     , 

^"^   I  accept^ces  are        J  P^^'^^  *^'°"g^  ^^^^^  ^'°^^'  °'  ^'°''- 

ers) 

Our  books  \  [  audited  by  a  certified  public  accountant. . . . 

are 


The  date  of  last  audit  was made  by. 


Bank  Accounts  Lines  Granted  Under  Discount  on  Statement  Date 


General  Partners: 


(Please  sign  firm's  name  here) . 


Personal  worth  outside  of  this  business     S. 

"       "       "  "         $. 

"       "       "  "         $. 


By 

(Partner) 
Date  signed 


Form  No.  3 

Corporation 
Manufacturer  or 
Merchant 

Name Business 

Address 

To  the Bank 


For  the  purpose  of  procuring  and  maintaining  credit  from  time  to 
time  in  any  form  whatsoever  with  the Bank,  for 


APPENDIX  B 


363 


claims  and  demands  against  the  undersigned,  the  undersigned 
submits  the  following  as  being  a  true  and  accurate  statement  of  its 

financial  condition  on  the day  of ,   19. . , 

and  agree  that  if  any  change  occurs  that  materially  reduces  the 
means  or  abihty  of  the  imdersigned  to  pay  all  claims  or  demands 
against  it,  the  undersigned  will  immediately  and  without  delay 
notify  the  said  Bank;  and  unless  the  Bank  is  so  notified  it  may  con- 
tinue to  rely  upon  the  statement  herein  given  as  a  true  and  accurate 
statement  of  the  financial  condition  of  the  undersigned. 


Assets 
Cash  on  hand  and  in  bank. .  .  . 
Accounts  of  customers  (good). 
Notes  and  acceptances  of  cus- 
tomers (good) 

Merchandise  (at  cost) : 


Liabilities 

Due  on  open  accounts 

Acceptances: 

(1)   Issued  in  payment  for  mer- 
chandise   

(2)  Other  acceptances . 


(1)  Manufactured Notes  payable  for  merchandise. 

(2)  Raw  material Notes  payable  to  own  banks. .  . 

(3)  Stock  in  process Notes  sold  through  brokers. .  .  . 

Notes  payable  to  others 

Notes  and  accounts  due  to  us  by 

controlled  or  allied  concerns 

Plant  and  machinery 

Furniture  and  fixtures 

Real  estate  (value-mortgage  en- 
tered in  liabilities) 

Other  assets  (itemized) 


Money  on  deposit  with  us 

Notes  and  accounts  due  by  us  to 
controlled  or  allied  concerns. .  .  . 

Other  current  debts  (itemized)..  . 

Bonded  debt — when  due 

Capital: 

Preferred 

Common 

Surplus 

Reserves 

Notes  receivable  and  acceptances 
discounted  or  sold  with  endorse- 
ment or  guarantee  (contingent 
liability) 


Total. 


Total. 


Condensed  Profit  and  Loss  Statement  for  Fiscal  Year  Ending 19 


Expense 

Cost  of  material  or  merchandise 
consumed 

Actual  expense  of  conducting  busi- 
ness.   Including  rent,  taxes,  in- 
surance, etc 

Salaries  paid  to  officers 

Interest  on  borrowed  money  and 
bonds 

Bad  debts  charged  off 

Depreciation  charged  off 

Net  profits 


Income 

Net  sales 

From  investments 

From  discounts  on  purchases. 
From  other  sources  (itemize) . . 


Total . 


Total. 


364  APPENDIX  B 

Reconcilement  of  Surplus 

ITndi vided  surplus  at  close  of  previous  fiscal  year S 

Less  charges  not  applicable  to  current  year $ $ 


Add  not  profits  as  above S S . 


Leas  dividends    (preferred) percent |. 

.ucod  uiYiucuuD    -^  eommon  J per  cent $ . 


Undivided  surplus $ 

Reverse  Side  of  Form  No.  3 

Contingent  Liability:  We  have  no  contingent  liability  of  any  kind  as 
endorser  or  guarantor  not  noted  above  (except  as  follows) 

Our  merchandise  is  insured  for  S Plant,  building  and 

machinery   $ Life   insurance   for  benefit  of  Company 

amounts  to  $ None  of  the  accounts  or  notes  receivable 

in  the  within  statement  have  been  assigned,  pledged  or  discounted 
(except  as  follows) 

Neither  have  any  of  our  other  assets  been  pledged  or  assigned  as 
collateral  for  any  of  oiu"  liabilities  (except  as  follows) 

Our  company  is  incorporated  under  the  laws  of  the  State  of 


We  have  no  interest  in  any  other  concern  (except — name  affiliations 

and  location) 

There  are  no  suits  pending  against  us  (except) 

The  form  of  obligation  used  in  the  financing  of  our  business  is  our 

plain  note  (endorsed  by) 

None  of  the  endorsers  guarantee  or  endorse  the  paper  of  other 
concerns  or  individuals  (except) 


Outside  resources  of  endorsers  are. 


Our  1  P  P         I  placed  through  (name  broker  or  brok- 

[  acceptances  are         J 


ers). 


APPENDIX  B  365 

-.      ,     ,      f  are  not  T  audited  by  a  certified  public  accountant. . . . 
1       are    J  

The  date  of  last  audit  was made  by 

Bank  Accounts  Lines  Granted  Under  Discount  on  Statement  Date 


Principal  Creditors  References 


Officers  Directors 

. . : President     

Vice-President     

Treasurer      

Secretary     

(Please  sigii  here) 

By 

Date  signed 19 . 


INDEX 


Accommodation  paper,  124,  125  148-152;  the  rise  of,  142-152; 


Accounts  receivable,  169-172 

Accrued  liabilities,  195,  196 

Adams,  A.  E.,  7,  273 

Adams,  Norman  I.,  4,  166 

Agger,  Eugene  E.,  66 

American  Bankers'  Association, 
146 

Assimilation  of  the  individual 
bank  to  the  system,  68-72 

Assumption,  Illinois,  45 

Atlantic  National  Bank  of  Jack- 
sonville, Fla.,  147 

Baker,  W.  H.,  133 
Baltimore,  Maryland,  45 
Bank  acceptances,  1,  2,  158-160 
Bank     borrowers'     statements, 
reciprocal    benefits   of,    209- 
211;  significance  of  refusal  to 
render,  211-213 
Bank  capital,  23 
Bank  credit,  the  nature  of,  1-4; 
vs.  commercial  credit,  3,  4; 
legitimate  scope  of  bank  credit 
extension,  4-9;  the  bank  ac- 
ceptance  as,    1,   2;    the   old 
theory    and    the    new    con- 
trasted, 72-74 
Bank  credit  department,  forces 
underlying    development    of, 


nature  and  work,  142,  143 

Bank  examinations,  internal  and 
external  distinguished,  295, 
296;  internal,  315-318;  in 
foreign  countries,  296 

Bank  supei-vision  in  relation  to 
bank  credit,  295 

Bankers'  banks,  the  nature  of, 
103;  dilute  cash,  104;  Federal 
Reserve  banks  illustrative  of, 
104-112 

Bankers'  Trust  Company  of 
New  York,  291, 292 

Banking  transactions  and  ac- 
counts, 13-20 

Banks  as  sources  of  credit  in- 
formation, 219-221 

Beal,  Thomas  P.,  Jr.,  279, 
288 

Benton,  Andrew  A.,  317 

Bills  payable,  for  merchandise, 
189;  to  own  banks,  189,  190; 
for  paper  sold,  190-191 

Blanding,  Lowrie  C,  213 

Bonded  debt  and  interest 
thereon,  192,. 193 

"Book"  surplus,  196 

Borrowers'  capacity,  207,  208 

Borrowers'  obligation,  evolution 
in  the  form  of,  123-131 


367 


368 


INDEX 


Borrowers'  statements,  form  of, 

162-164 
Boston,  Massachusetts,  45,  137 
Branch  banking,  in  relation  to 

note  brokerage,  140,  141 
Brokers'  paper,  new  attitude  of 

bankers  toward,  141 
Byerly,  T.  J.,  236 

Cannon,  J.  G.,  146, 216, 221 

Capital  and  surplus  of  bank 
borrower,  161,  165,  196,  197 

Carthage,  Illinois,  45 

Cash  on  hand  and  in  banks,  in 
borrowers'  statements,  165- 
169 

Cash,  in  relation  to  loan  expan- 
sion in  indi\adual  and  collec- 
tive banking,  77,  78 

Cash  withdrawals,  201,  202 

"Cash  credits,"  235 

Case,  J.  Herbert,  272 

Central  Reserve  cities,  104, 
113 

Chase  National  Bank  of  New 
York,  65,  145 

Chattel  mortgages,  192 

Claflin,  H.  B.,  286 

Claflin,  The  H.  B.  Company  of 
New  York,  285,  286 

Claremont,  New  Hampshire,  45 

Chemical  National  Bank  of 
New  York,  65 

Clearing  house  bank  examina- 
tion, 302;  the  system  de- 
scribed, 304-306;  in  relation 
to  loans  of  small  banks,  310- 
312;  in  relation  to  "double" 


borrowers,  312;  incidental  ef- 
fects upon  loans,  313 
Clews,  Henrj^,  131,  133 
Coates,  Francis,  308,  312 
Commercial  banking,  the  nature 

of,  13-31. 
Commercial  banks  as  bankers' 

banks,  119,  120 
Commercial  paper  houses,  260- 
294;    characteristic    features, 
260-262;  the  paper,  262-264; 
form  of  business,  264,  265; 
profit  of,  265-267;  advantages 
of  to  borrowers,  267-270;  dis- 
advantages of  to  borrowers, 
270, 271 ;  advantages  to  banks, 
271-276;     disadvantages    to 
banks,  277.    See,  also,  Note 
brokerage 
Concealed  assets,  28-30,  253 
Concealed  liabilities,  30 
Concealed  profits,  253 
Concentration  of  reserves,  120 
Conover,  Samuel  S.,  274 
Cooke,  Thornton,  237 
Contingent  liabilities,  194,  195 
Copyrights,  185 
Corn  Exchange  Bank  of  New 

York,  226 
Corn  Exchange  National  Bank 

of  Chicago,  147 
Crabb,  John  A.,  247,  249 
Craig,     Justice     C.    C,    245, 

249 
Craig,  W.  Oliver,  167,  180 
Corpus  Christi,  Texas,  46 
Crane,  F.  W.,  205-215,  273 
Crawford,  J.  H.,  237,  240 


INDEX 


369 


Criticism,  anticipated,  an- 
swered, 74,  76 

Country  banks,  104 

Credit  worth,  161,  198 

Current  liabilities,  162,  164, 
197 

Davis,  C.  H.,  6 
Deane,  D.  H.,  234 
Deferred  assets,  185 
Deferred  liabilities,  195 
Deming,  J.  K.,  134 
Denver,  Colorado,  46 
Deposits,    are    deposits    bank 

credit?  2,  3;  why  banks  com- 
pete for,  66-68 
"Deposits  of  money  with  us," 

193 
Depreciation,  202-204 
Derivative  deposits  defined  and 

distinguished   from   primary, 

40-44 
Derivative  deposits,  ratio  of  to 

loans,  44-46 
Derivative  deposits,  aggregate, 

tend  to   remain   constant  in 

amount,  52 
Des  Moines  National  Bank,  75 
Dillon,  W.  G.,  239,  249 
Dividends,  206 
Double  liability,  23 
Drake,  R.  H.,  251 

Earnings,  205,  206 
Elkhart,  Indiana,  45 
Endorsed  paper,  126-130,  247, 

263 
Equipment,  182 


Erie,  Pennsylvania,  45 
Exchange,  19 

Federal  Reserve  Act,  104 

Federal  Reserve  Act  and  bank 
examination,  299 

Federal  Reserve  banks;  location 
of,  104;  ownership  of,  104, 105; 
reserves  of,  105;  functions 
of,  105,  106;  loans  of,  109;  as 
bankers'  banks,  104-112;  in 
relation  to  note  brokerage, 
138 

Federal  Reserve  Bank  of  Cleve- 
land, 116 

Federal  Reserve  Bank  of  New 
York,  116 

Federal  Reserve  bank  notes,  109 

Federal  Reserve  Board,  105-113 

Federal  Reserve  notes,  107,  108, 
109,  110,  111,  112 

Federal  Reserve  system,  123; 
membership  in,  104,  105; 
future  credit  expansion  under, 
112,  113;  influence  of,  upon 
kind  and  quality  of  bank 
loans,  156-160 

Fire  insurance,  201 

First  National  Bank  of  New 
York,  145 

First  National  Bank  of  Boston, 
145 

First  National  Bank  of  Denver, 
147 

First  National  Bank  of  San 
Francisco,  147 

First  National  Bank  of  Weston, 
Ohio,  258,  259 


370 


INDEX 


Flatau,  Herman,  192 

Flynn,  S.  R.,  216,  219 

Forgan,  James  B.,  124, 125, 126, 
222 

Foster,  A.  C,  207 

Fourth  National  Bank  of  New 
York,  145 

Fourth  National  Bank  of  At- 
lanta, Georgia,  147 

Frankfort,  Kentucky,  45 

Freeport,  Ilhnois,  45 

Gage,  William  T.,  186,  226 

Galesburg,  Illinois,  45 

Good  wiU,  185 

Gordon,  W.  C.,  244,  246 

Government  deposits,  109 

Greenville,  South  CaroHna,  45 

Gurney,  E.  R.,  246,  250 

Haden,  Charles  J.,  228 

HamUn,  Charles  S.,  157 

Hand    books    as    a    source    of 

credit  information,  215 
Hannan,  Charles  R.,  272 
Hanover  National  Bank  of  New 

York,  37,  38 
Hazlitt,  Henry,  118,  119 
Hepburn,  A.  Barton,  187 
Herrick,   Clay,    162,   167,   171, 

172,  205 
Howell,  Eugene,  241 

Implied  warranties,  126 
Income  account,  199-206 
Independent  banking  and   the 

rise  of  note  brokerage,  139 
Individual  bank  loan  expansion 


traceable  to  the  acquisition  of 
primary  deposits,  quantita- 
tive determination  of,  54-57; 
formula  for  determination  of, 
55,  56,  115;  qualifications  of 
formula,  57-59 

International  Paper  Company, 
registration  of  commercial 
paper  of,  291,  292 

Interview  the,  as  a  means  of 
securing  credit  information, 
221 

Investigating  the  borrowing 
bank,  256-259 

Investigating  the  credit  risk, 
214-223;  method  in  a  par- 
ticular case,  222,  223 

Johnson,  E.  L.,  233 
Johnson,  J.  H.,  179 

Kains,  A.,314 

Kavanaugh,    Thomas    J.,    170, 

201 
Klein,  J.  J.,  127 

Lacey,  E.  S.,  4 

Lending  power  of  the  banking 

system,  38-40 
Life  insurance,  186-188 
Life  insurance  policies  as  col- 
lateral security,  225,  226 
Lipman,  F.  L.,  228 
Livingston,  William,  226 
"Loan  expansion"  defined,  59 
Loans,  expansion  of,  a  prelude  to 

loss  of  cash,  20-22 
Loans,  relation  of,  to  deposits, 
63,64 


INDEX 


371 


Loans;  secured,  224-234;  ware- 
house, 226;  cotton,  229,  230; 
crop,  230,  231 ;  secured  by  real 
estate  mortgage,  231-234;  of 
country  banks,  242-252;  to 
tenants,  249;  of  banks  to 
banks,  253-259 

Long,  R.  A.,  210 

Lowry  National  Bank  of  At- 
lanta, Georgia,  147 

Lynch,  Jas.  K.,  244 

Machinery  and  equipment,  181, 
182 

Mad  River  National  Bank  of 
Springfield,  Ohio,  116,  117 

Manchester,  New  Hampshire, 
45 

Martin,  W.  McC,  157 

Martindale,  Joseph  B.,  190,  212, 
222 

Mechanics'  and  Metals  Na- 
tional Bank  of  New  York,  118, 
145,  222,  223 

Medina,  Ohio,  45 

Meek,  Charles  E.,  174 

Mercantile  agencies  as  sources 
of  credit  information,  215 

Merchandise,  164,  173,  179 

Merchants'  and  Mechanics' 
First  National  Bank,  Balti- 
more, Maryland,  147 

Milford,  New  Hampshire,  45 

Mills,  A.  L.,  241,  274 

Mississippi  Valley  Trust  Com- 
pany, St.  Louis,  Mo.,  147 

Morgan  City,  La.,  46 

Morrill,  E.  N.,  245 


Moulton,  H.  G.,  6,  84,  85,  86,  87 
Murray,  Lawi-ence  0.,  298,  299, 

302 
McGrath,  A.  J.,  255 

National  Association  of  Credit 
Men,  146 

National  bank  notes,  19,  109 

National  banks,  loans  of,  128, 
130 

National  Bank  of  Commerce, 
New  York,  145 

National  Bank  of  Commerce, 
St.  Louis,  Mo.,  147 

National  City  Bank  of  New 
York,  145 

National  Park  Bank  of  New 
York,  145 

National  bank  supervision,  296- 
299 

National  Reserve  Bank  of  Kan- 
sas City,  Mo.,  147 

National  Shawmut  Bank  of 
Boston,  145 

Naumburg,  E.,  124 

Nelson,  John  M.,  225 

New  business  department;  rise 
of,  152-155;  relation  of  to 
bank  credit  department,  155 

New  England  cotton  mills,  de- 
preciation of,  203 

Newport,  New  Hampshire,  45 

New  reserve,  the  distribution  of 
as  a  foundation  of  manifold 
new  loans,  58-63 

New  worth,  165,  196,  197;  rela- 
tion of  to  credit  worth, 
198 


372 


INDEX 


New  York  banks,  loans  of,  127, 
128 

New  York,  N.  Y.,  45,  137 

Non-liability  paper,  256 

Note  brokerage  system;  weak- 
nesses of,  277-287;  correc- 
tives, 287-294;  growth  of, 
131-141 

Notes  receivable,  169,  172 

O'Brien,  W.  H.,  301 

Open  accounts,  "frozen"  credit, 
158;  in  borrowers'  statements, 
191 

Option  in  the  purchase  of  brok- 
ers' paper,  265 

Organization  expenses,  185 

Oskaloosa,  Iowa,  46 

Overdrafts,  16,  17,  235-241; 
comptroller  of  the  currency 
issues  ruling  against,  236; 
objectionable  features  of,  237, 
238;  in  state  and  national 
banks,  238,  239;  rules  for  con- 
trolling, 239,  240;  dependent 
upon  bank  supervision,  240; 
an  index  of  the  soundness  of 
banks,  241 

Overflow  cash,  54, 57, 59,  60,  61, 
62 

Page,  Edward  D.,  127 
Parker,  Robert  A.,  198,  212 
Patents,  185 
Permanent  assets,  162 
Permanent  liabilities,  162 
Philosophy  of  bank  credit,  32- 
76 


Pierre,  South  Dakota,  46 
Post,   William,    149,    173,   174, 

178,  179,  182,  194,  219,  221 
Primary  deposits,  differentiated 

from  derivative,  40-44 
Profits,  199,  201,  205,  206 
Proprietorship  interest,  165, 196, 

197 
Protective  liabiUties,  22-28 

Quick  assets,  ratio  of  to  current 
liabiUties,  197 

Rate  of  interest,  250-252 
Ratio  of  derivative  deposits  to 

loans,  factors  determining  the, 

46 
Ratio   of   cash   to   deposits   in 

individual    bank,    regulation 

of,  79-82 
Ratio  of  cash  to  deposits  and  to 

loans  in  the  banking  system, 

82,  83 
Ratio  of  reserve  to  deposits  vs. 

ratio    of    surplus    to    credit 

UabiUties,  102 
Read,  Albert  M.,  226,  228 
Real  estate,  179-181 
Reckitt,  Ernest,  169 
Rediscount  rate  as  a  factor  in 

credit  extension,  114-118 
Rediscount  rate  in  relation  to 

the  general  price  level,  117, 

118 
Rediscount  rate  in  relation  to 

volume  of  trade,  117,  118 
Rediscount  rate  and  the  tradi- 
tional theory  of  bank  credit, 

118 


INDEX 


373 


Regional  banks  (Federal  Re- 
serve banks)  regarded  as  one 
bank  of  branches,  106,  107 

Registration  of  commercial  pa- 
per, 291-293 

Reserve,  relation  of,  to  demand 
liabilities,  20,  21 

Reserve  deposits,  defined,  106; 
volume  of,  109 

Reserve  liability,  23-25 

Reserves,  legally  required,  108; 
centralization  of  111,  120 

Reserve,  relation  of  to  surplus, 
94-96 

Reserve  cities,  103,  104 

Residual  cash,  73 

Rockport,  Massachusetts,  45 

Roe,  Louis  M.,  177 

Salaries,  201,  202 

Salem,  Massachusetts,  45 

San   Francisco,   Cahfornia,  46, 

50 
Sales,  204,  205 
Schmidt,  J.  L.,  272 
Schryver,  R.  H.,  237 
Scottsville,  Kentucky,  45 
ScoviUe,  C.  C.  K.,  247 
Seattle  National  Bank,  Seattle, 

Washington,  147 
Sensenich,  Edgar  H.,  225 
Shepperd,  Owen,  291 
Sims,  R.  N.,  238 
Single  name  paper,   127,    128, 

129,  262 
Slow  and  past  due  paper,  rules 

for  reducing,  248,  249 
Slow  assets,  162 


Smith,  C.  T.,  251 

Smith,  W.  H.,  236 

Smith,  W.  W.,  187 

Smylie,  R.  W.,  232 

Snyder,  F.  B.,  205,  220 

Southwest  National  Bank  of 
Commerce,  Kansas  City,  Mo., 
147 

St.  Joseph,  Mo.,  as  a  jobbing 
and  credit  center,  136 

State  bank  supervision  in  rela- 
tion to  bank  loans,  299-302 

Stocks  and  bonds  in  borrowers' 
statements,  183,  184 

Surplus,  25-29 

Surplus  reserve,  formula  for  the 
determination  of  the  amount 
that  a  bank  can  lend  on  the 
basis  of,  71 

Surplus,  a  new  but  erroneous 
doctrine  of,  84-94 

Surplus  and  reserve,  tendency 
toward  direct  variation  be- 
tween, 96-101 

Surplus  reserve,  108 

Talbert,  Jos.  T.,  139,  276,  280, 

302 
Ten  days'  option  in  the  purchase 

of  brokers'  paper,  265 
Thompson,  R.G.,  229 
Tiffin,  Ohio,  45 
Tootle-Lacy  National  Bank,  St. 

Joseph,  Mo.,  147 
Trade  acceptances,  158,  159 
Trade,  the,  as  a  source  of  credit 

information,  216-220 
Trade-marks,  184,  185 


374 


INDEX 


Traditional  theory  of  banking,  a 

critical  analysis  of,  34-38 
Tregore,J.H.,176 
Turnover,  204, 205 

Undivided  profits,  25-29 
United  States  National  Bank  of 
Portland,  Oregon,  147 

Valuation  of  assets,  27,  29 
Van  Vechten,  Ralph,  280,  289, 
293,  307,  312, 313 


Weston,  W.S.,  211,244 
Wexler,  Sol,  313,  314 
Wheeler,  H.  A.,  208 
White,  Horace,  36 
Whitfield,  William,  171-175 
Whitney-Central    Nat'l    Bank, 

New  Orleans,  La.,  147 
Wilson,  A.  W.,  231 
Wilson,  J.  W.,  311,  312 
Wing,  Daniel  G.,  203 
Wyhe,  James  R.,  282 

Zimmerman,  H.  M.,  309 


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